Reviewed by Oct 05, 2020| Updated on
A contract unit is the total value of the underlying asset that particular futures or derivatives contract represents. The underlying asset may be anything from agricultural commodities and metals to currencies and interest rates that are exchanged on a futures exchange.
Thanks to the high standardisation of futures contracts, the contract unit must specify the exact amount and requirements of the commodity, such as the number and quality of oil barrels or the amount of foreign currency. A contract unit for an options contract is 100, which means that each deal is for buying or selling 100 shares.
The unit of a contract is a vital exchange decision where it is exchanged. If the device is too large, the exchange would not be fit for use by several investors and traders who wish to hedge smaller exposures.
However, if the unit of a contract is too low, trading is costly because there is a cost associated with each exchanged contract. Some exchanges introduced the "micro" contract model for attracting and retaining smaller investors.
A contract unit makes it easy for investors to select how many contracts they need to hedge their exposure to. For instance, a U.S. company that has to pay C$1 million in three months to its Canadian supplier and wants to hedge its exposure to a rising Canadian dollar can do so by buying 10 CAD/USD futures contracts.
The downside of uniform contract units is the inability to create a complete hedge. For example, if a U.S. company is required to pay C$1.05 million to its Canadian supplier in three months, hedging C$1 million or C$1.1 million will only be possible due to the standardised contract unit. The U.S. corporation is forced to hedge Canadian dollars too much or too little.