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Upon expiration, the futures contract might stipulate that the short party now deliver to the long
party the specified quantity of wheat. The long party must now pay the short party the spot price for
this wheat. Yes, the spot price, not the original futures price! The difference between the terminal spot
price and the original futures price has already been paid via marking to market. A numerical example
will make the mechanics of futures clearer and show how similar futures are to forwards.
Suppose with five days remaining until expiration, the wheat futures price is $4.00 per bushel. A
baker buys a futures contract in order to lock in a purchase price of $4.00. Suppose the futures prices
on the next four days are $4.10, $3.90, $4.00, and $4.25. The spot price on the fifth day, the expiration
day, is $4.30. Given those price movements, short pays the long baker 10 cents the first day. The long
baker pays short 20 cents on the second day. On the third day, short pays long 10 cents, followed by a
payment from short to long of 25 cents on the fourth day, and a payment from short to long of 5 cents
on the last day. On net, over those five days, short has paid long 30 cents. When long now pays the
spot price of $4.30 to short for delivery of the wheat, long indeed is paying $4.00 per bushel, net of the
30 cents profit on the futures contract. Recall that $4.00 was the original futures price. Thus, the
futures contract did effectively lock in a fixed purchase price for the wheat.
A contract that stipulates a spot transaction in which the underlying commodity is actually delivered
at expiration is called a “physical delivery” contract. Many futures contracts do not stipulate such a
final spot transaction with actual delivery of the underlying asset. After the last marking to market, the
game is over—no assets are delivered. Contracts that stipulate no terminal spot transaction are called
“cash settled.” It should make little difference to traders whether a contract is cash settled or physical
delivery. A cash settled contract can be turned into a physical delivery deal simply by choosing to
make a spot transaction at the end. Likewise, a physical delivery contract can be turned into a cash
settled deal either by making an offsetting spot transaction at the end or by exiting the futures contract
just before it expires.
Examples of the Use of Forwards and Futures in Risk Management
A wide variety of underlying assets is covered by futures and forwards contracts these days. For
example, exchange-traded futures contracts are available on stocks, bonds, interest rates, foreign
currencies, oil, gasoline, grains, livestock, metals, cocoa, coffee, sugar, and even orange juice.
Consequently, these instruments are versatile risk management tools in a wide variety of situations.
The most actively traded futures, however, are those that cover financial risks. Consider the following
examples.
A Foreign Currency Hedge
Suppose an American electronics manufacturer has just delivered a large shipment of finished
products to a customer in France. The French buyer has agreed to pay 1 million euros in exactly 30
days. The manufacturer is worried that the euro may be devalued relative to the American dollar
during that interval. If the euro is devalued, the dollar value of the promised payment will fall and the