What Are The Key Features Of A Futures Contract In Procurement?
Are you curious about the fascinating world of futures contracts in procurement? Whether you’re a seasoned professional or just starting, understanding the key features of this unique trading instrument can help you make more informed decisions and navigate the market with confidence. In today’s blog post, we’ll dive into what exactly futures contracts are, how they work and how to use them to your advantage in procurement. So buckle up and let’s explore together!
What is a futures contract?
A futures contract is a legally binding agreement to buy or sell a commodity at a specified price on a specified date in the future. Futures contracts are standardized by exchange, including the quantity and quality of the underlying commodity, the month and year of delivery, and the price increment.
The buyer of a futures contract agrees to purchase the underlying commodity from the seller at a set price on a given date in the future. The seller agrees to provide that commodity at that price on that date. The buyer pays a deposit, known as margin, to enter into the contract. If at any time before the expiration date of the contract, the value of the underlying commodity rises above the agreed-upon price (known as the strike price), then the buyer profits; if it falls below that price, then the buyer loses money. At expiration, ifthe underlying commodity’s spot price is abovethe strike price, thenthe option expires worthless tothe seller but in-the-moneytothe buyer; however, ifspot prices arebelowstrike prices atthe time ofexpiration,thenoptionsexpire worthless toboth parties.
What are the key features of a futures contract?
A futures contract is a standardized, legally binding agreement to buy or sell a certain asset at a predetermined price at a specified time in the future. Futures contracts are traded on exchanges and can be used for a variety of assets, including commodities, stocks, bonds, and currencies.
The key features of a futures contract are:
1. Contract Size: The contract size is the amount of the underlying asset that is traded. For example, most equity futures contracts are for 1,000 shares of stock.
2. Price: The price of the futures contract is the price at which the underlying asset will be bought or sold. The price is determined by the market and can change frequently during trading hours.
3. Expiration Date: The expiration date is the date when the contract expires and must be settled. Most futures contracts have an expiration date of three months from the date of trade, but some contracts have shorter or longer terms.
4. Delivery: Delivery refers to the process by which the underlying asset is exchanged between the buyer and seller at expiration. With most commodities, delivery takes place through an exchange-approved warehouse or other storage facility. With stocks and bonds, delivery often occurs through electronic transfer on settlement day.
How can a futures contract be used in procurement?
Futures contracts can be used in procurement to hedge against price movements in the underlying commodity. By buying a futures contract, the buyer is able to lock in a price for the commodity at a future date, which protects them from rising prices. Conversely, if prices of the commodity fall, the buyer is still obligated to purchase the commodity at the higher futures price, providing downside protection.
Futures contracts can also be used to speculate on price movements of commodities. Traders can take long or short positions in futures contracts, betting that prices will rise or fall. If correct, traders can make profits from these bets. However, if incorrect, traders can incur losses.
Pros and cons of using a futures contract in procurement
When it comes to procurement, there are a few key features of futures contracts that can be beneficial, but there are also some potential drawbacks to consider.
One of the main advantages of using a futures contract is that it can help protect against price fluctuations. If the price of a commodity goes up unexpectedly, the buyer is still only obligated to pay the agreed-upon price. This can provide some stability and predictability in procurement planning.
However, there are also some risks associated with futures contracts. For example, if the price of a commodity falls below the agreed-upon price, the buyer may be required to make up the difference. This could lead to unexpected expenses and losses for the business.
Overall, whether or not to use a futures contract in procurement is a decision that should be made on a case-by-case basis. Weighing the pros and cons carefully can help ensure that the best decision is made for each individual situation.
Alternatives to using a futures contract in procurement
There are a number of alternatives to using a futures contract in procurement. These include forwards, swaps, and options. Each has its own advantages and disadvantages, so it is important to understand each before making a decision.
Forwards are the simplest alternative to futures contracts. They are simply agreements to buy or sell an asset at a specified price on a specified date. There is no up-front payment required, and the only risk is that the price of the asset may change between the time the contract is agreed upon and the delivery date.
Swaps are another alternative to futures contracts. A swap is an agreement between two parties to exchange cash flows in the future. The most common type of swap is an interest rate swap, where one party agrees to pay fixed interest payments to the other party in exchange for variable interest payments based on market rates. Swaps can be used to hedge against changes in interest rates or other variables, but they also involve counterparty risk.
Options are yet another alternative to futures contracts. An option gives the holder the right, but not the obligation, to buy or sell an asset at a specified price on or before a certain date. Like swaps, options involve counterparty risk and can be used to hedge against changes in prices or other variables.
Conclusion
A futures contract in procurement can be a great way to secure the goods or services you need for your business. Knowing the key features of a futures contract can help ensure that both parties are aware of their obligations and responsibilities, ensuring that everyone is on the same page and making it easier to complete a successful transaction. With its ability to protect both sides from any potential risks associated with price changes, it’s easy to see why many companies choose this type of contract when procuring goods or services.