Futures

Definition

Futures are standardized contracts that obligate the buyer to purchase, and the seller to sell, a specified asset at a predetermined price at a future date. These contracts are widely used in financial markets for hedging risks and speculating on price movements. By locking in prices ahead of time, participants can manage uncertainty in various markets, including commodities, currencies, and financial instruments.

5 Must Know Facts For Your Next Test

1. Futures contracts are traded on exchanges such as the Chicago Mercantile Exchange (CME), ensuring transparency and liquidity in the market.
2. These contracts can be based on various underlying assets, including agricultural products, metals, energy products, and financial indices.
3. The use of leverage in futures trading allows traders to control larger positions with a smaller amount of capital, increasing both potential gains and risks.
4. Futures are marked to market daily, meaning profits and losses are settled at the end of each trading day, which can affect traders' margin requirements.
5. Market participants include hedgers who want to protect against price fluctuations and speculators aiming to profit from expected price changes.

Review Questions

• How do futures contracts facilitate risk management for businesses dealing with volatile commodities?
  • Futures contracts help businesses manage risk by allowing them to lock in prices for commodities they need, such as oil or grain. By entering into these contracts, companies can stabilize their budgeting and planning since they know exactly how much they'll pay for raw materials in the future. This predictability is crucial for businesses that face fluctuating market prices, enabling them to safeguard against potential losses from rising costs.
• Discuss the role of leverage in futures trading and its implications for both potential profits and risks.
  • Leverage plays a significant role in futures trading as it allows traders to control large positions with relatively small amounts of capital. While this can amplify potential profits when trades go well, it also increases the risk of substantial losses if the market moves unfavorably. Traders must be aware of their margin requirements and monitor their positions closely to avoid margin calls, which can lead to forced liquidation of positions during volatile market conditions.
• Evaluate how the daily marking-to-market of futures contracts impacts traders' strategies and overall market dynamics.
  • The daily marking-to-market of futures contracts significantly influences traders' strategies because it requires them to settle profits or losses each day based on market performance. This process not only affects liquidity but also compels traders to manage their margin accounts carefully, impacting their willingness to hold positions over longer periods. As a result, this practice contributes to overall market volatility as participants react to price changes and adjust their strategies accordingly, which can lead to increased trading activity during periods of uncertainty.

Related terms

Options: Options are financial derivatives that give the buyer the right, but not the obligation, to buy or sell an asset at a specified price within a specified time frame.

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

Margin: Margin refers to the funds required to open and maintain a position in a futures contract, acting as collateral for the trade.