Market Strategy

Futures contract

| Updated on December 15, 2012 Published on December 15, 2012

Last week, we saw how a wheat grower can lock-in a price at present and protect his profit margin even though delivery of wheat from his side may take place at a future date.

Like a farmer, a primary producer who is able to protect his profit margin irrespective of the market price at the time of delivery by locking-in a price in advance, anyone who wants to buy a commodity for delivery at a future point of time can buy a ‘futures contract’ to lock-in a price at present in order to secure himself against any adverse price movement at the time of delivery.

For instance, someone wants to buy gold at a future point of time, say for a wedding in the family.

In some way, in the above examples, the seller of wheat and the buyer of gold belong to a category of market participants called the ‘hedgers’.

So, hedgers are those who face price risks of the underlying commodity (wheat and gold, here) and want to protect themselves against potential adverse price changes by transferring such risk. Such transferred risks are borne by a category of market participants called the ‘speculators’.

Simply put, speculators bet on the future price of any asset including commodities.

So, if a speculator believes that the price of wheat will be above Rs 1,200 a quintal (as in last week’s example) in the following March, it makes economic sense for him to buy it from the farmer at Rs 1,200 a quintal in October itself.

Here, there is coincidence of wants leading to a futures transaction. Commodity markets by their very nature are volatile. Day to day movement in the price of futures contracts of commodities reflects the changing perception of market participants on a daily basis.

One distinguishing feature of the futures market is that the futures price converges with spot price on the date of expiry of the contract.

Thus, along with providing a platform for risk management, commodity derivatives market also performs the function of price discovery for both spot and futures markets.

Price discovery and price risk management are the two principal pillars on which the futures market edifice is built.

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