Why are futures contracts important?

On the surface, futures contracts are an instrument of price speculators who want to hedge a price risk or profit from coming changes. In the jargon of the futures market, these participants might be called "hedgers" and "speculators," respectively. However, there are other, more significant social and economic functions that futures contracts play. These intangible financial instruments help to foster a greater specialization that benefits all consumers by allocating resources more efficiently and providing an insurance policy for businesses.

Futures contracts have drawn plenty of critics ever since their inception. These critics often claim forward contracts might serve an important purpose, but standardized and traded futures contracts are inherently speculative and therefore add unnecessary risk to the financial markets. These concerns make sense in a vacuum but are poorly represented among dynamic and fluctuating futures contract prices.

The nature of both futures and forward contracts is that one party goes "long" and the other "short." When changes in relevant future prices occur, one party directly benefits and the other is penalized. This makes speculation seem like sanctioned financial gambling. However, the losing party in a futures contract does not necessarily regret its decision. This is because one party is entering the contract to hedge away risk, while the other is accepting future risk for potential gain. The negative or positive market value offsets the losses or gains from other sources, ostensibly.

Take, for example, an airline company. Its profitability is very closely tied to the spot price of oil, which is required to fuel air travel. When oil prices surge, operating costs shoot up and the airline's solvency is put at risk. However, oil prices are not controlled by airliners; the risk of rising oil is consistent regardless of management decisions. So the oil companies may make the rational decision to purchase large quantities of futures contracts in oil. This way, if prices rise, the costs are offset by the growing value of the futures. The price of oil might plummet instead. The airliner benefits from lower fuel prices even though the futures are, in this context, a losing proposition. Either way the airline "wins."

In an economic sense, there is no real distinction between interregional price differences, or the price of wheat in Ukraine versus its price in Japan, and intertemporal price differences, or the price of wheat one day versus its price a month later.

Consider an arbitrager who notices wheat can be purchased cheaply in Ukraine and sold for a large profit in Japan. This helps transfer resources from those who value it less highly, such as the wheat-saturated consumers in Ukraine, to those who value it more highly. This process continues until all arbitrage profits are eliminated.

It is in this manner that futures contracts send signals about value and help coordinate production. Consider a world where most investors expect the world supply of wheat to plummet the next day. There is an incentive to go long on wheat, expecting the price to rise. In other words, high future value is communicated. Wheat producers, or potential producers, could look at the high value of wheat in a month and increase their future production, which helps offset the future shortage.