Future Derivative

What is Future Derivative

An agreement between two parties for the purchase and delivery of an item at a certain price at a later time is known as a futures contract, or simply future derivative. Standardized contracts known as futures are traded on an exchange. A futures contract is used by traders to manage risk or make predictions about the value of an underlying asset. The parties are required to carry out an agreement to purchase or sell the underlying asset.

 

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Understanding with Example

Say, for illustration, that on Nov. 6, 2021, Company A purchases an oil futures derivative or future contract with an expiration date of Dec. 19, 2021, at a cost of $62.22 per barrel. The reason the corporation takes this action is that it needs oil in December and is worried that the price will increase before it must buy. Because the seller is required to provide oil to Company A for $62.22 per barrel after the contract expires, purchasing an oil futures derivative /contract helps the company to hedge its risk. Assume that by December 19th, 2021, oil will cost $80 per barrel. Company A has the option to accept delivery of the oil from the futures contract seller, but it also has the option to sell the contract before it expires and pocket the profits if it decides it no longer needs the oil.

In this instance, the buyer and seller of futures both insure against risk. Company A required oil in the future and intended to take a long position in an oil futures contract to reduce the chance that the price would increase in December. The vendor might be an oil firm worried about falling oil prices that wanted to eliminate that risk by selling or shorting a futures contract that fixed the price it would get in December.

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