Understanding Futures
In the field of finance, a future contract is a binding standardized legal agreement to purchase or sell something in a specified period of time in the future, by parties not necessarily known mutually to each other. The object transacted in a future is normally a financial or asset. A futures market is used when trading commodities and currencies. Futures contracts are traded daily on stock markets as well as over the counter (OTC) commodity exchanges such as the London Metal Exchange and the New York Board of Trade (NYBOT).
Futures contracts follow a standard formula for determining the value of an asset or instrument at the time it is expected to be valued. This value is called the intrinsic value of the underlying and will be different from the current market value. The underlying assets or instruments are identified in the formula as well as the interest rate and the duration of the contract.
Forward contracts refer to those contracts where the seller posts a cashier’s check for delivery on the future date. These are usually settled by the buyer at the point of sale. Futures brokers determine the fair market value of the underlying asset before the buyer actually signs the agreement. The forward contract buyer also makes certain adjustments to determine the potential losses to the buyer if the trade goes against them.