Futures Contracts

Definition

Futures contracts are standardized agreements to buy or sell a specific asset, such as a commodity or financial instrument, at a predetermined price and future date. These contracts are traded on organized exchanges and are used to manage price risk and speculate on future price movements.

5 Must Know Facts For Your Next Test

1. Futures contracts are standardized in terms of the quantity, quality, and delivery date of the underlying asset, making them easily tradable on exchanges.
2. Participants in the futures market include producers, consumers, and speculators, each with different motivations for buying or selling futures contracts.
3. Futures contracts are marked-to-market daily, meaning that gains and losses are settled daily, which helps to manage counterparty risk.
4. Margin requirements, which are the initial deposits required to enter a futures contract, help to ensure the financial integrity of the futures market.
5. The use of leverage in futures trading can amplify both gains and losses, making it a high-risk, high-reward investment strategy.

Review Questions

• Explain how futures contracts can be used to manage foreign exchange rate risk.
  • Futures contracts can be used to manage foreign exchange rate risk by allowing companies or individuals to lock in a specific exchange rate for a future transaction. For example, a company that needs to make a payment in a foreign currency at a future date can sell a foreign exchange futures contract to hedge against adverse movements in the exchange rate. This provides the company with certainty about the exchange rate it will receive, helping to mitigate the risk of unfavorable currency fluctuations.
• Describe how futures contracts can be used to manage commodity price risk.
  • Futures contracts can be used to manage commodity price risk by allowing producers, consumers, and traders to lock in a specific price for a future purchase or sale of a commodity. For instance, a farmer can sell a futures contract for their crop, ensuring a guaranteed price regardless of market conditions at the time of harvest. Similarly, a manufacturer that relies on a particular commodity as a raw material can buy a futures contract to fix the price they will pay, protecting their profit margins from unexpected increases in the commodity's spot price.
• Evaluate the role of speculators in the futures market and their impact on price discovery.
  • Speculators play a crucial role in the futures market by providing liquidity and contributing to price discovery. By taking positions in futures contracts, speculators help to establish the market price based on their expectations of future supply and demand. While speculators do not have a direct commercial interest in the underlying asset, their participation helps to ensure that futures prices reflect all available information and provide an accurate signal of future price movements. However, excessive speculation can also lead to price volatility and the potential for market distortions, which is why regulatory bodies monitor the futures market to maintain its integrity and stability.

Related terms

Commodity Futures: Futures contracts that involve the purchase or sale of physical commodities, such as agricultural products, metals, or energy resources.

Financial Futures: Futures contracts that involve the purchase or sale of financial instruments, such as currencies, interest rates, or stock indexes.

Hedging:

The practice of taking an offsetting position in a futures contract to reduce the risk of adverse price movements in the underlying asset.