Futures

Definition

Futures are standardized financial contracts that obligate the buyer to purchase, and the seller to sell, a specific asset at a predetermined price on a specified future date. They are often used for hedging or speculative purposes, allowing traders to lock in prices for commodities, currencies, or financial instruments ahead of time. Futures are traded on exchanges, making them a key part of derivatives markets.

5 Must Know Facts For Your Next Test

1. Futures contracts can be based on various underlying assets, including agricultural products, metals, energy, and stock indices.
2. They require a margin payment upfront, which is typically a fraction of the total contract value, allowing traders to leverage their positions.
3. Futures are marked-to-market daily, meaning profits and losses are settled at the end of each trading day, impacting the trader's margin account.
4. The settlement of futures can occur either through physical delivery of the asset or through cash settlement, depending on the contract specifications.
5. Market participants use futures not just for speculation but also for hedging against price fluctuations in the underlying assets they deal with.

Review Questions

• How do futures contracts differ from options contracts in terms of obligations and rights?
  • Futures contracts obligate both parties—the buyer must purchase and the seller must sell the asset at the agreed price on the specified date. In contrast, options contracts provide the holder with the right but not the obligation to buy or sell an underlying asset at a specified price. This fundamental difference means that while futures have mandatory execution at expiration, options give flexibility and choice to the holder.
• Discuss how margin requirements impact trading strategies in futures markets.
  • Margin requirements play a crucial role in futures trading as they allow traders to control larger positions with less capital. By requiring only a fraction of the contract's total value as collateral, margin enables traders to leverage their investments, potentially amplifying both gains and losses. This dynamic can lead to increased volatility in traders' accounts as they are subject to daily mark-to-market adjustments based on market movements.
• Evaluate the role of futures in risk management strategies for businesses dealing with commodities.
  • Futures serve as an essential tool for businesses engaged in commodity production or consumption by allowing them to hedge against price volatility. For instance, a farmer may sell futures contracts for their crops to lock in prices before harvest, safeguarding against potential price declines. Similarly, companies that rely on raw materials can buy futures to stabilize costs and budget more effectively. This proactive approach to risk management helps businesses maintain financial stability despite fluctuating market conditions.

Related terms

Options:

Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price before a certain date.

Margin:

Margin refers to the collateral that an investor must deposit with a broker when trading futures contracts to cover potential losses.

Hedging:

Hedging is a risk management strategy used to offset potential losses in investments by taking an opposite position in a related asset or security.