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 primarily used for hedging against price fluctuations and speculation in various markets, including commodities, currencies, and financial instruments. By locking in prices ahead of time, they help manage financial risks and stabilize cash flows for businesses.

5 Must Know Facts For Your Next Test

1. Futures contracts can be traded on exchanges, allowing for standardized terms and improved liquidity compared to over-the-counter transactions.
2. They can be used for a wide variety of underlying assets, such as agricultural products, metals, energy sources, and financial instruments like stock indices.
3. The use of futures contracts allows companies to stabilize their production costs and protect themselves from adverse price movements in their inputs or outputs.
4. Futures markets are regulated by government bodies to ensure transparency and reduce the risk of default between parties.
5. The settlement of futures contracts can occur through physical delivery of the asset or cash settlement, depending on the contract terms.

Review Questions

• How do futures contracts function as a risk management tool for businesses in volatile markets?
  • Futures contracts serve as a crucial risk management tool for businesses by allowing them to lock in prices for essential commodities or financial assets. By securing these prices ahead of time, companies can stabilize their costs and forecast their budgets more accurately, mitigating the impact of price fluctuations. This is particularly important in volatile markets where changes in supply and demand can lead to significant financial uncertainty.
• Evaluate the role of futures contracts in corporate risk management policies and their impact on financial performance.
  • Futures contracts play an essential role in corporate risk management policies by providing a structured way for companies to hedge against potential losses from price volatility. By incorporating these contracts into their financial strategies, businesses can better manage cash flows and protect profit margins, ultimately enhancing overall financial performance. The effectiveness of these strategies can significantly influence a company's stability and competitive edge in the market.
• Assess the implications of leveraging futures contracts on both potential returns and risks associated with corporate investments.
  • Leveraging futures contracts can amplify both potential returns and risks for corporate investments. On one hand, using futures can lead to significant profits if market conditions move favorably; however, if prices move against the position taken, losses can be magnified due to the use of margin. This duality highlights the importance of understanding market trends and having effective risk management strategies in place, as companies must balance the pursuit of higher returns with the inherent risks associated with leveraged trading.

Related terms

Options:

Contracts that give the holder the right, but not the obligation, to buy or sell an asset at a specified price within a defined timeframe.

Hedging:

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

Margin: The collateral required to enter into a futures contract, which ensures that both parties can fulfill their obligations.