Futures Contract

A futures contract is a form of a derivative.  It is a contract to buy a specified asset at a specified price at a specified future date. It is a tool to manage financial risk. 

Here’s how it works. Suppose a company has an obligation to pay a debt of US$1 million in 8 months time.  The company is based in Australia, and normally trades in its own local currency (AUD).  In order to protect itself from the uncertain currency fluctuation, it decides to purchase a futures contract to buy US$1 million in 8 months time from a bank at a guaranteed exchange rate of USD1 = AUD 1.7.  The contract specifies that the company will buy $1 million in 8 months,  at the pre-determined exchange rate.  By having this contract, the company does not have to worry about whether the US$ will fluctuate against its favour. It is guaranteed to be able to buy $1 million at the specified exchange rate.

If at the 8 month period, the exchange rate becomes USD 1.00 = AUD 2.00, the company is able to purchase the USD1 million at AUD1.7 million, very much in its favour.  The downside of course is that if at the 8-month period, the exchange rate has become USD1 = AUD1, then the company will be purchasing the USD1 million at an unfavourable, though surprise-free, rate.