Lily is the owner of a coffee shop. Every month, Lily buys raw coffee beans from Emma’s farm for 2$ per bag. Both girls are happy with this price, and decide to write up a futures contracts to protect themselves from price changes.
A contract for assets (especially commodities or shares) bought at agreed prices but delivered and paid for later.
To sign a futures contract, both Lily and Emma meet with an investor separately, and the investor handles the transaction. Lily signs a contract stating that she will purchase the coffee at 2$/bag in the future, and Emma signs a contract stating that she will sell her coffee at 2$/bag in the future. Any changes in price will be dealt by the investor.
These contracts protect both Lily and Emma from the risk of volatile price changes:
For example, if the coffee market becomes more competitive, the price of coffee will drop, and Emma will be forced to sell her coffee bags at a cheaper rate thus losing money.
On the other hand, if poor weather affects the coffee crops, the price of coffee will increase, and Lily will have to pay more for her bags of coffee.
Thus, by having a future contract in place, the “risk of the unknown” goes away, and both girls know exactly what to expect in the future. They can continue their business operations without worry.
So what does the investor have to do with all this?
Well, if the price of coffee goes under 2$ per bag, the investor promises to pay Emma the difference so that she doesn’t lose any money. However, if the price goes over 2$ per bag, the investor gets to keep the extra profits from Emma’s sales.
On the other hand, if the price goes down, Lily will still pay the investor 2$ per bag and the investor will profit from the difference. If the price goes up, the investor will cover the difference and Lily will still pay only 2$.
Of course, there is potential for an upside or downside for both Lily, Emma and the investor when signing a futures contract. However, both girls get to benefit from ditching the “risk of the unknown”.