Futures contracts

Definition

A futures contract is a standardized legal agreement to buy or sell a specific asset at a predetermined price at a specified time in the future. These contracts are traded on exchanges and serve to manage the risk of price fluctuations, making them especially important in foreign currency transactions and for hedging against foreign currency risk. They allow businesses and investors to lock in prices, providing a level of certainty in uncertain markets.

5 Must Know Facts For Your Next Test

1. Futures contracts are commonly used in foreign currency transactions to stabilize the costs associated with currency exchange fluctuations.
2. These contracts are standardized in terms of contract size and expiration dates, which makes them easier to trade on exchanges compared to customized agreements.
3. Investors use futures contracts as part of their hedging strategy to protect against adverse movements in currency rates, reducing the potential negative impact on cash flows.
4. The margin requirement for futures trading allows investors to control a larger position with a smaller amount of capital, but it also increases risk due to the potential for margin calls.
5. Futures contracts can be settled either through physical delivery of the asset or cash settlement, depending on the nature of the contract and the preferences of the parties involved.

Review Questions

• How do futures contracts function as a tool for managing foreign currency transactions?
  • Futures contracts function by allowing businesses to lock in exchange rates for future transactions, which helps them manage potential fluctuations in currency prices. When a company anticipates needing to convert a specific amount of foreign currency in the future, they can enter into a futures contract at the current rate. This means that regardless of market changes, they will pay or receive the agreed-upon rate, thus stabilizing their costs and reducing uncertainty associated with foreign currency transactions.
• Discuss the advantages and disadvantages of using futures contracts for hedging foreign currency risk.
  • Using futures contracts for hedging foreign currency risk offers several advantages, such as locking in prices and reducing uncertainty about future costs. This can protect companies from adverse currency movements that could negatively impact their profitability. However, there are disadvantages too; if the market moves favorably after entering into a contract, companies may miss out on potential gains. Additionally, futures require margin deposits and can lead to significant losses if not managed properly.
• Evaluate the impact of futures contracts on international trade and investment strategies in volatile markets.
  • Futures contracts significantly impact international trade and investment strategies by providing mechanisms for risk management in volatile markets. They enable companies to stabilize costs associated with foreign currency transactions, making it easier for them to plan budgets and forecast profits. By using these contracts, businesses can enter new markets with reduced fear of adverse exchange rate movements, thus promoting international trade. However, while they mitigate risks, improper use can also amplify losses and create financial instability if market conditions shift unexpectedly.

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 the value of an underlying asset, such as stocks, bonds, currencies, or interest rates.

Spot market: A market where financial instruments, such as currencies or commodities, are bought and sold for immediate delivery and payment.