Futures

Definition

Futures are financial contracts that obligate the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price. They are widely used in the context of financial instruments and risk management strategies.

5 Must Know Facts For Your Next Test

1. Futures contracts are standardized in terms of the quantity, quality, and delivery time and location of the underlying asset.
2. Futures markets provide a centralized platform for trading, with the exchange acting as the counterparty to both the buyer and seller.
3. Futures contracts can be used to speculate on the future price movements of an asset or to hedge against the risk of adverse price changes.
4. The value of a futures contract is derived from the underlying asset, and its price fluctuates based on the supply and demand of the asset in the market.
5. Margin requirements and daily settlement (marking-to-market) are important features of futures trading that help manage counterparty risk.

Review Questions

• Explain how futures contracts are used as financial instruments and their role in risk management.
  • Futures contracts are financial instruments that allow investors to speculate on the future price movements of an underlying asset or to hedge against the risk of adverse price changes. In the context of financial instruments, futures provide a standardized and centralized platform for trading a variety of assets, including commodities, currencies, and financial instruments. From a risk management perspective, futures can be used to mitigate the risk of price fluctuations by locking in a predetermined price for the future purchase or sale of an asset. This can be particularly useful for businesses that need to manage the price risk of their inputs or outputs, such as a manufacturer hedging the cost of raw materials or a farmer locking in the selling price of their crop.
• Describe the key features of futures contracts that distinguish them from other financial instruments, such as forward contracts and options.
  • Futures contracts have several unique features that differentiate them from other financial instruments like forward contracts and options. Firstly, futures contracts are standardized in terms of the quantity, quality, and delivery time and location of the underlying asset, making them more liquid and easier to trade on organized exchanges. Secondly, the exchange acts as the counterparty to both the buyer and seller, which helps manage counterparty risk through mechanisms like margin requirements and daily settlement (marking-to-market). In contrast, forward contracts are private agreements between two parties, and options provide the right, but not the obligation, to buy or sell the underlying asset. These differences in standardization, counterparty risk management, and the nature of the contract (obligation vs. right) are important considerations when choosing the appropriate financial instrument for risk management or speculative purposes.
• Evaluate the role of futures markets in the broader financial system and their importance for risk management strategies employed by businesses and investors.
  • Futures markets play a critical role in the broader financial system by providing a centralized and regulated platform for trading a wide range of assets, from commodities to financial instruments. These markets serve several important functions, including price discovery, risk transfer, and the facilitation of commercial hedging activities. For businesses and investors, futures markets offer valuable risk management tools, allowing them to hedge against the price volatility of their inputs, outputs, or investment portfolios. By locking in future prices through futures contracts, companies can mitigate the impact of adverse price movements and improve their financial planning and decision-making. At the same time, the speculative activity in futures markets contributes to market liquidity and price discovery, which benefits all participants. Overall, the efficient functioning of futures markets is essential for the effective management of risk and the smooth operation of the broader financial system.

Related terms

Forward Contract: A forward contract is a private agreement between two parties to buy or sell an asset at a specified price on a future date.

Options:

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

Hedging:

Hedging is a risk management strategy that aims to reduce or eliminate the risk of adverse price movements in an asset.