Futures contracts

Definition

Futures contracts are legally binding agreements to buy or sell a specific asset at a predetermined price on a set future date. These contracts are commonly used to hedge against risks associated with price fluctuations, especially in foreign currency exchange rates. By locking in prices, businesses can protect themselves from potential losses due to adverse movements in currency values.

5 Must Know Facts For Your Next Test

1. Futures contracts are standardized and traded on exchanges, making them highly liquid compared to other forms of contracts.
2. They can be used not just for currencies but also for commodities, stocks, and interest rates, providing flexibility for various types of hedging.
3. When using futures contracts for hedging foreign currency risk, companies can stabilize their costs or revenues in their home currency by locking in exchange rates.
4. The margin system in futures trading requires traders to deposit a fraction of the contract's total value as collateral, allowing them to control larger positions with less capital.
5. Mark-to-market accounting means that the gains or losses on futures contracts are settled daily, impacting a company's financial statements immediately.

Review Questions

• How do futures contracts function as a hedging tool for businesses dealing with foreign currency risk?
  • Futures contracts function as a hedging tool by allowing businesses to lock in exchange rates for future transactions. When a company anticipates receiving payments in a foreign currency or making purchases abroad, it can enter into a futures contract to set the exchange rate now, protecting against potential unfavorable fluctuations in the market. This way, companies can stabilize their financial planning and reduce the unpredictability associated with foreign currency transactions.
• What are the main differences between futures contracts and forward contracts in the context of hedging currency risk?
  • The main differences between futures and forward contracts include their trading venues and standardization. Futures contracts are standardized agreements traded on exchanges, which makes them more liquid and regulated. In contrast, forward contracts are customized agreements traded over-the-counter, offering flexibility but less liquidity. Additionally, futures contracts require daily settlements through mark-to-market accounting, while forward contracts typically settle at the contract's expiration date. These differences impact how businesses choose to hedge currency risks based on their specific needs.
• Evaluate the impact of using futures contracts on financial reporting for companies exposed to foreign currency risk.
  • Using futures contracts can significantly impact financial reporting for companies exposed to foreign currency risk. The daily mark-to-market process means that any gains or losses from these contracts are recognized immediately in the financial statements, influencing earnings volatility. This recognition can affect key financial ratios and overall perceived performance. Additionally, companies must manage disclosures related to their hedging strategies and any associated risks, which adds another layer of complexity to financial reporting and analysis.

Related terms

Hedging:

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

Forward Contracts: Similar to futures contracts, these are agreements to buy or sell an asset at a future date, but they are usually customized and traded over-the-counter rather than on an exchange.

Derivatives: Financial instruments whose value is derived from the value of an underlying asset, such as currencies, commodities, or securities.