Futures

Definition

Futures are financial contracts obligating the buyer to purchase, and the seller to sell, a specific asset at a predetermined price on a specified future date. They are used primarily for hedging risk and speculation in financial markets, enabling participants to manage exposure to price fluctuations in various assets such as commodities, currencies, and financial instruments.

5 Must Know Facts For Your Next Test

1. Futures contracts are standardized and traded on exchanges, which helps ensure liquidity and transparency in the market.
2. The margin system allows traders to enter futures positions with only a fraction of the contract's value, amplifying both potential gains and losses.
3. Futures can be settled either through physical delivery of the underlying asset or through cash settlement, depending on the contract terms.
4. Hedgers use futures to lock in prices for assets they plan to buy or sell in the future, protecting themselves against adverse price movements.
5. Speculators trade futures with the hope of profiting from changes in market prices, taking on higher risks without the intention of physical delivery.

Review Questions

• How do futures contracts serve as a tool for hedging risk in financial markets?
  • Futures contracts help manage risk by allowing participants to lock in prices for assets they will buy or sell in the future. For example, a farmer can use futures to guarantee a selling price for their crops before harvest, protecting against potential declines in market prices. This use of futures enables businesses to stabilize costs and budget effectively while reducing uncertainty related to price fluctuations.
• Discuss the differences between futures and options contracts in terms of their functions and risks involved.
  • Futures contracts obligate both parties to execute the trade at the agreed-upon price on the expiration date, creating an inherent obligation that carries higher risk. In contrast, options contracts give buyers the right but not the obligation to execute the trade. This distinction means that options can limit potential losses while providing flexibility. However, options typically require premium payments upfront, which is not necessary with futures unless margin requirements apply.
• Evaluate how market volatility influences trading strategies involving futures contracts and the implications for hedgers and speculators.
  • Market volatility significantly impacts trading strategies for both hedgers and speculators. In highly volatile markets, hedgers may increase their use of futures contracts to protect against sharp price movements, thereby stabilizing their financial planning. Conversely, speculators might see volatility as an opportunity for profit, employing strategies that capitalize on rapid price changes. However, increased volatility can also elevate risks; thus, both groups must carefully assess their exposure and risk management techniques when engaging with futures.

Related terms

Hedging:

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

Options:

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.

Contract Specifications: Detailed terms of a futures contract including the underlying asset, contract size, expiration date, and settlement method.