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 primarily used in the commodities market but can also apply to financial instruments, providing a way for investors to hedge against price fluctuations or speculate on future price movements.

5 Must Know Facts For Your Next Test

1. Futures contracts are traded on exchanges like the Chicago Mercantile Exchange (CME), ensuring transparency and standardized terms.
2. Both buyers and sellers are obligated to fulfill the terms of the contract at expiration, which can lead to significant financial gains or losses.
3. Futures can be used for various assets, including commodities like oil and gold, as well as financial instruments like currencies and stock indices.
4. Leverage is commonly used in futures trading, allowing investors to control larger positions with a smaller amount of capital, increasing both potential gains and risks.
5. Settlement of futures contracts can occur in two ways: physical delivery of the asset or cash settlement based on the price difference at expiration.

Review Questions

• How do futures contracts provide opportunities for both hedging and speculation?
  • Futures contracts serve as a tool for hedging by allowing investors to lock in prices for assets they intend to buy or sell in the future, reducing their risk of price fluctuations. On the other hand, speculators use these contracts to bet on price movements without necessarily having an interest in the underlying asset. This dual function makes futures contracts appealing to various market participants seeking to manage risk or profit from market changes.
• Evaluate the role of exchanges in trading futures contracts and how they contribute to market efficiency.
  • Exchanges play a crucial role in facilitating futures contracts by providing a regulated marketplace where participants can trade with confidence. They ensure standardized terms, which reduces ambiguity and increases liquidity. This structure enhances market efficiency by allowing for quicker price discovery and enabling participants to execute trades easily. The presence of exchanges also helps mitigate counterparty risk, making trading safer for all parties involved.
• Assess the impact of leverage in futures trading on both investor strategies and market stability.
  • Leverage in futures trading allows investors to control larger positions with less capital, potentially amplifying returns on investment. However, this same leverage can lead to significant losses if market movements do not align with investor expectations. While it creates opportunities for higher profits, excessive leverage can contribute to market volatility and instability. Investors must balance the use of leverage with effective risk management strategies to navigate these potential pitfalls successfully.

Related terms

Options:

Options are financial derivatives that give the holder the right, but not the obligation, to buy or sell an underlying asset at a specified price within a certain timeframe.

Hedging:

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

Spot Market: The spot market is where financial instruments or commodities are traded for immediate delivery, as opposed to a futures contract which specifies a delivery date in the future.