Risk Hedging with Future Contracts

Definition: The Future Contract is a standardized forward contract between two parties wherein they agree to buy or sell the underlying asset at a predefined date in the future and at a price specified today. The future contracts are a relatively less risky alternative of hedging against the fluctuations in the currency market.

The parties to the currency future contracts fix the rate today while the actual payment or the delivery is made on the specified date in the future. There are two types of futures: Commodity Futures and Financial Futures. In commodity future, the contract is for the commodity such as cocoa or aluminum, while the financial futures refer to the future contract in financial instruments such as treasury bills, stock or currency.

The investor has a choice to exchange his currency either in the spot market or the futures market. In the spot market, the currency is exchanged at the current rate and the payment is made right away, whereas, in the future market, the exchange rate is fixed today while the actual payment is made at the defined future date. The difference between the spot and the future market can be illustrated in the form of an equation given below:

Future Price/ (1+Risk-free rate of interest) = Spot price – Present value  of interest or dividend forgone

Where, the Spot price is the current exchange rate prevailing at the time the currencies are being exchanged, while the contract rate is the rate which has been locked at the time the parties agreed to the transaction.

Through this formula, both the parties to the future contract decide whether they have incurred gains or suffered losses. Here also, the buyer hopes that the currency may appreciate while the seller expects that the currency will depreciate.

Now the question may arise, that what is the difference between the forward contracts and the future contracts when both of these instruments look alike? Well, there are significant differences between these two tools of hedging that can be read from the link given below:

Difference Between Forward Contracts and Future Contracts