Futures are financial contracts. The buyer purchases an asset in advance at a preset rate; futures are standardized to trading on a future date but at a price set earlier.
This contract makes the buyer obliged to buy and a seller to deliver the asset. On the other hand, the actual delivery of the asset is unusual in real life as futures are used for price speculation of the commodity or hedging.
Hedging is essentially locking down a price in advance. The price will be the forecast of the asset at the time in the future and not the current price. If a company is certainly going to buy an asset in the future, it hedges to remove the uncertainty in price due to fluctuations.
This makes planning easier, improved investing, and distribution of funds. The risk of sudden hike in price can be removed. The company is held to take a long position.
A short hedge is the same deal for the seller. If the selling company is certainly selling the asset in the future, it locks down on the future price. Buyers can turn to sellers of the same picky contract, but contrasting in the share marke he will be essentially buying the asset and then reselling it if it comes to settlement.
Price speculation is the forecast of the price of an asset in the future financial market. Speculation is significant for hedging as, without the future price, hedging would not be a model.
As the future trading is based on the future of the asset, it is called a derivative contract.
Derivatives are financial instruments that obtain its value from another value; therefore, as the future price is dependent on the trends of the asset and its current or spot value, it is called a derivative.
Forward contracts, futures and hedging are widespread with commodity trading.
To get a clear picture on this we can take the example of the airline industry
This industry focuses more on the fuel as it utilizes fuel in huge amounts on an everyday basis. It is essential for them to get their fuel inflow at fixed and steady prices without letting any market performance affect their inventory.
For this reason the airlines practice hedging to ensure that they do not incur any risk for the company or the investors of the company.Without hedging, oscillation in commodities can lead to the bankruptcy of companies that require accurate forecast to handle their expenses.
Equity shares don’t expire but futures have an expiration date. They are traded on futures exchanges and, in India, can be traded at most popular exchanges like NSE (National Stock Exchange), BSE (Bombay Stock Exchange), MCX (Multi Commodity Exchange), MCX SX, etc.
Physical delivery and cash settlement are the 2 ways to settle a futures contract.
Delivery is the processing out of the contract and cash settlement is the paying/receiving the loss/gain associated to the contract when it expires.