Do you know what a futures contract is?
A futures contract is a contractual arrangement between the existent parties that one of them will sell and the other will buy a particular commodity at a particular set time in the future date at a particular set price.
Now this agreement is extremely important because if there is any upward swing or a disastrous downward swing in the price of the commodity that is future contracted, the company will be at least sure of getting the price that it has set. And this way it can eliminate all losses because of the benefit of hedging the futures contract.
If hedging is not done in the futures contract then the companies can suffer untold losses and can even become bankrupt if it is not sufficiently prepared for any market exigencies.
Let us see this with an example:
Say a company ABC is contemplating buying 100 tons of steel from the market because it is expecting an order from a foreign automobile giant. Six months in advance the price of steel per tonnage is $100 and it is expected to increase to 110. Now if this company ABC hedges a futures contract for a price of 110 dollars per tonnage (only hypothetical) then even if the price is $115 per tonnage the company will be entitled to procure it at its agreed hedged price.
This makes it easier for the company to work out its costs and set off its losses against its profits so that not only does it breakeven but makes enough profits to be able to meet its overheads and have a little left as profits.
Similarly, if the company wants to sell a commodity and it wants to hedge the commodity as a futures contract, it makes it easier for it to get an agreed price without making excessive losses.
The idea is to neutralize risks:
The main reason why companies prefer to use futures contract is that the risk exposure of such corporations is spread evenly the exposure to risk is limited. By hedging a futures contract, the company or the big corporation can know exactly how much its position is safeguarded.
Of course, it is impossible to avoid losses totally in a business where the nature of the business itself is speculation. Therefore, hedging the futures contract can to a lot extent remove the surprise (rather shock) element in the trading.
What happens if that particular commodity is not available for futures contract?
If you have been reading a lot of information and blogs on helpful applications such as Infinity app, you may have realized that not all commodities are available for futures contract. If this is the case, it is always recommended that a similar commodity be followed instead of that.Read More