Futures Contracts

Definition

Futures contracts are legally binding agreements to buy or sell a specific asset at a predetermined price on a specified future date. These contracts are commonly used in financial markets to hedge against risks associated with price fluctuations, allowing businesses and investors to stabilize costs and revenues over time.

5 Must Know Facts For Your Next Test

1. Futures contracts can be used for various assets, including commodities like oil, gold, and agricultural products, as well as financial instruments like currencies and stock indices.
2. These contracts are standardized and traded on exchanges, which ensures transparency and liquidity in the market.
3. Futures contracts require a margin deposit, which is a fraction of the total contract value, allowing traders to leverage their investments.
4. Participants in futures markets include hedgers, who aim to protect against price changes, and speculators, who seek profit from price movements.
5. Settlement of futures contracts can occur through physical delivery of the asset or cash settlement, depending on the terms agreed upon in the contract.

Review Questions

• How do futures contracts function as a risk management tool for businesses?
  • Futures contracts serve as a crucial risk management tool for businesses by allowing them to lock in prices for essential inputs or outputs. This helps stabilize costs and predict future cash flows, thereby reducing uncertainty caused by price volatility. For instance, a farmer can sell futures contracts for their crop before harvest to ensure they receive a guaranteed price, mitigating the risk of falling prices at harvest time.
• Compare and contrast futures contracts with options contracts in terms of their structures and purposes.
  • Futures contracts are obligations to buy or sell an asset at a set price on a future date, while options contracts give the holder the right but not the obligation to do so. Both are derivatives used for hedging and speculation; however, futures require both parties to fulfill the contract at expiration, while options allow flexibility. This difference in structure influences how each is used in financial risk management strategies.
• Evaluate the impact of futures contracts on market efficiency and liquidity in financial markets.
  • Futures contracts enhance market efficiency and liquidity by enabling quick price discovery and allowing participants to manage their risk effectively. The standardized nature of these contracts ensures that they can be easily bought and sold on exchanges, attracting a wide range of participants. This increased trading volume contributes to tighter bid-ask spreads and more accurate pricing of underlying assets, ultimately promoting stability in financial markets.

Related terms

Hedging:

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

Derivatives: Financial instruments whose value is derived from an underlying asset, such as stocks, bonds, or commodities.

Margin: The collateral that an investor must deposit with a broker to cover the credit risk posed by their open futures positions.