Futures contracts

Definition

A futures contract is a standardized legal agreement to buy or sell a specific asset, like commodities or financial instruments, at a predetermined price on a specified future date. These contracts are traded on exchanges and are used primarily for hedging risk or speculating on price movements, which connects them to various financial market activities and risk management strategies.

5 Must Know Facts For Your Next Test

1. Futures contracts are standardized, meaning that they specify the quantity, quality, and delivery date of the underlying asset, which makes them easily tradable on exchanges.
2. They are commonly used in various markets, including agricultural commodities like wheat and corn, as well as financial instruments like currencies and stock indices.
3. Futures contracts can be settled either by physical delivery of the asset or through cash settlement, where the difference between the contract price and market price is paid.
4. They play a crucial role in price discovery by providing information about future expectations of supply and demand in the market.
5. Traders can leverage their positions in futures contracts, which means they can control larger amounts of assets with a relatively small initial investment.

Review Questions

• How do futures contracts facilitate risk management for businesses that rely on commodity prices?
  • Futures contracts help businesses manage risk by allowing them to lock in prices for the commodities they need. For instance, a farmer can sell futures contracts for their crop before harvest to secure a set price, protecting against the possibility of falling prices at harvest time. This enables businesses to plan their budgets more effectively and reduces uncertainty related to commodity price fluctuations.
• Discuss the differences between hedging and speculation in the context of futures contracts.
  • Hedging involves using futures contracts to protect against potential losses from price fluctuations in an underlying asset, while speculation is aimed at profiting from those price changes. Hedgers seek to reduce risk and stabilize costs, such as farmers locking in prices for their crops. In contrast, speculators aim to take advantage of market movements without any intention of actually buying or selling the underlying asset, often accepting higher risks for the potential of higher rewards.
• Evaluate the impact of margin requirements on trading behavior in futures markets and how it influences overall market volatility.
  • Margin requirements play a significant role in futures trading by determining how much capital traders need to put up to control larger positions. This leverage allows traders to amplify their returns but also increases their exposure to risk. If market conditions shift unfavorably, it can lead to margin calls where traders must add more funds or close positions. Such dynamics can contribute to increased market volatility, especially during periods of rapid price movement or economic uncertainty.

Related terms

Hedging:

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

Speculation: Speculation involves buying and selling assets with the hope of making a profit from future price changes, often involving higher risk.

Margin: Margin refers to the collateral that an investor must deposit with a broker when borrowing funds to trade futures contracts, helping manage credit risk.