What is a futures contract and why were they created

A futures contract is simply a contract that involves delivery of some specific asset by a seller to a buyer at an agreed-upon future date.  In addition to specifying a future delivery date the buyer and seller also agree upon the price and quantity to be delivered.  However full payment is not due until the time of delivery.  To insure that both buyer and seller are financially able to meet the contract terms, each is required to post a deposit at the time that the contract is entered into.

The earliest organized futures contracts in the U.S. involved the buying and selling of grain.  To demonstrate the economic usefulness of futures contracts we will use the example of a corn farmer and a corn miller.  A corn farmer expends significant financial resources in the spring of each growing season but has no certainty regarding his future revenue at harvest time.  Concurrently a corn miller may have agreed to a long term selling commitment to deliver corn starch and corn oil but is uncertain about the future cost of corn at harvest time.  Therefore both buyer and seller have reason to create some certainty about the future price of corn later in the year.  In this example, when the farmer is planting his crop, he could choose to sell his expected crop prior to harvest at a fixed price.  The corn miller, by buying the farmer's expected crop, can solve his economic uncertainty by locking in a specific cost for raw material to be delivered later in the year.  Thus the economic basis of the futures contract is to provide price certainty in what otherwise would be a highly uncertain economic future for both buyer and seller.

In our example the farmer and the miller could enter into a direct contract with each other; however, neither would be able to extricate themselves from the contract without the other's concurrence.  By establishing a uniform contract and trading it on a futures exchange, each party to the contract could undo his side of the transaction by offsetting his initial position with a third party on any business day prior to the contract's delivery date.  The farmer, in our example, might have a crop failure and be unable to meet the delivery terms.  He could buy back the contracts that he sold earlier.  The miller may have purchased more bushels than he needs.  He would therefore sell some of the contracts that he had purchased earlier. On any particular day there may be an imbalance of commercial and producer interests buying and selling. To facilitate a liquid market, third party traders and investors are needed.  They may see an opportunity to speculate on the direction of prices and to take advantage of temporary imbalances caused by the varying requirements of commercial participants.  In summary, the participation of a wide variety of commercial and investment interests with different objectives for entering the market gives the market greater  liquidity.

It is often stated that trading futures is a "zero sum game," in other words for every dollar made, there is a dollar lost.  While this is true in the sense that each transaction requires a buyer and a seller at a similar price, the goals of various participants in each transaction are often quite different.  Most commercial or producer participants in the futures markets are seeking to eliminate future price uncertainty.  They are less concerned with "catching" a high or low price than they are with establishing future price certainty that will allow them to remain economically viable.  This desire for price certainty or "price insurance" on the part of the commercial or producer participants allows the futures investor to capture return for in effect becoming the insurance provider.

Futures contracts were initially developed for physical commodities such as raw materials and food stuffs.  Today futures markets also include contracts on a wide variety of financial instruments such as bonds, currencies and stock indexes. 

Futures contracts are standardized for each individual market in terms of size, expiration date, price trading increments, hours traded, and margin deposit requirements. 

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