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FUTURES CONTRACTS

For many years, futures contracts on physical commodities have been traded. In recent years, active markets have developed for financial futures contracts. This chapter describes futures contracts for physical commodities and the use of futures contracts in risk reduction and hedging. Chapter 15 examines financial futures contracts and their uses.

A futures contract involves a contractual agreement to purchase or sell something at a future point in time, called the delivery month.1 The buyer is called the long and the seller is called the short. Futures contracts are zero-sum games; that is, the short and the long are playing against each other. The long's gains equal the short's losses and vice versa.

The actual purchase of the commodity is not scheduled to take place until the delivery month, as shown in Figure 14.1. For example, suppose a contract is signed for the short to deliver 1 ounce of silver in 1 year for a price of $8.00. Figure 14.2 shows the futures obligations.

In fact, most futures contracts are closed out by an offsetting position before delivery occurs. A long offsets by going short; a short offsets by going long. Imagine an investor who has taken a short position in silver futures at $8.00 per ounce on March 15 as shown in Figure 14.3. The scheduled delivery date is September 15. Any time before that delivery date, the short can offset the short position by going long. For example, suppose that on March 16 the short decides to close the position ...

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