What is a Futures Contract?
Futures101 - 05 April 2006

[NFA] - There are two types of futures contracts, those that provide for physical delivery of a particular commodity or item and those which call for a cash settlement. The month during which delivery or settlement is to occur is specified. Thus, a July futures contract is one providing for delivery or settlement in July.

It should be noted that even in the case of delivery-type futures contracts,very few actually result in delivery.* Not many speculators have the desire to take or make delivery of, say, 5,000 bushels of wheat, or 112,000 pounds of sugar, or a million dollars worth of U.S. Treasury bills for that matter. Rather, the vast majority of speculators in futures markets choose to realize their gains or losses by buying or selling offsetting futures contracts prior to the delivery date. Selling a contract that was previously purchased liquidates a futures position in exactly the same way, for example, that selling 100 shares of IBM stock liquidates an earlier purchase of 100 shares of IBM stock. Similarly, a futures contract that was initially sold can be liquidated by an offsetting purchase. In either case, gain or loss is the difference between the buying price and the selling price.

Even hedgers generally don't make or take delivery. Most, like the jewelry manufacturer illustrated earlier, find it more convenient to liquidate their futures positions and (if they realize a gain) use the money to offset whatever adverse price change has occurred in the cash market.

* When delivery does occur it is in the form of a negotiable instrument (such as a warehouse receipt) that evidences the holder's ownership of the commodity, at some designated location.

Since delivery on futures contracts is the exception rather than the rule, why do most contracts even have a delivery provision? There are two reasons. One is that it offers buyers and sellers the opportunity to take or make delivery of the physical commodity if they so choose. More importantly, however, the fact that buyers and sellers can take or make delivery helps to assure that futures prices will accurately reflect the cash market value of the commodity at the time the contract expires--i.e., that futures and cash prices will eventually converge. It is convergence that makes hedging an effective way to obtain protection against an adverse change in the cash market price.*

* Convergence occurs at the expiration of the futures contract because any difference between the cash and futures prices would quickly be negated by profit-minded investors who would buy the commodity in the lowest-price market and sell it in the highest-price market until the price difference disappeared. This is known as arbitrage and is a form of trading generally best left to professionals in the cash and futures markets.

Cash settlement futures contracts are precisely that, contracts which are settled in cash rather than by delivery at the time the contract expires. Stock index futures contracts, for example, are settled in cash on the basis of the index number at the close of the final day of trading. There is no provision for delivery of the shares of stock that make up the various indexes. That would be impractical. With a cash settlement contract, convergence is automatic.

(c) National Futures Association - nfa.futures.org