Let us see the below example to understand the features of future contract
Suppose Crude oil is currently trading at USD 100 per barrel. Oil Refiner X wants to buy crude oil to protect itself from the huge volatility of the crude oil price.
To do the same, the company will buy 1-month crude oil future contract which is currently trading at USD 102 per barrel.
Suppose after 1-month at the time of expiry the crude oil price rises to USD 110 per barrel and the future price will be same at USD 110 per barrel at the time of expiry.
The company will gain USD 8 per barrel to protect itself from the price rise of the crude oil price. So its affective buy rate of crude oil price will be USD 102 per barrel after 1-month.
Suppose after 1-month at the time of expiry the crude oil price falls to USD 90 per barrel and the future price will be same at USD 90 per barrel at the time of expiry.
The company will lose USD 12 per barrel in this case and its affective buy rate of crude oil price will be USD 102 per barrel after 1-month.
So whatever the case may be, its effective buy rate will be same at the end of expiry of the future contract. Thus future contracts help to hedge against the volatility of the price movements.
Future contracts are widely used in currency segment to hedge against any potential currency rate movement. Let us see the another example to understand the currency Future contract
Suppose current INR/USD currency exchange rate is INR 45 per USD and Rupee is expected to appreciate in next one month due to dollar depreciation. For a software exporter rupee appreciation can hurt their margin and profitability badly. To hedge against the same one Indian software company X buys an INR/USD currency future contract at INR 44.5 per USD which will be expired in next three months.
Suppose after three months the Indian rupee has appreciated much more than expected and touched the rate of INR 43 per USD. At the time of expiry the future rate will also be the same.
Because of the future contract, The Company X will gain INR 1.5 per USD and its effective currency will stay at INR 44.5 per USD even after 3 months.
The converse is true for Rupee depreciation as well.
Future contracts help exporter companies to hedge themselves from any volatility or currency rate movement in the future.
This is how the companies and trader can hedge against any commodities price and currency movements or price volatility using future contracts.