Futures Contracts

Definition

A futures contract is a legally binding agreement to buy or sell a specific asset at a predetermined price on a specified future date. These contracts are typically used in commodities trading, but they can also apply to financial instruments, such as currencies and stock indices. Futures contracts are essential for hedging risk and speculating on price movements, making them a significant part of alternative investments.

5 Must Know Facts For Your Next Test

1. Futures contracts are standardized agreements traded on exchanges, which means the terms are set by the exchange and ensure liquidity and transparency.
2. The main participants in the futures market include hedgers, who use contracts to protect against price fluctuations, and speculators, who aim to profit from those price changes.
3. Margin requirements are essential in futures trading, as they allow traders to control larger positions with a smaller amount of capital, amplifying both potential gains and losses.
4. Futures contracts can be settled either by physical delivery of the underlying asset or by cash settlement, depending on the nature of the contract.
5. These contracts play a critical role in price discovery and market efficiency, as they reflect traders' expectations about future supply and demand for the underlying assets.

Review Questions

• How do futures contracts serve as a tool for both hedgers and speculators in the investment market?
  • Futures contracts provide hedgers with a way to protect their investments from adverse price movements by locking in prices for the assets they wish to buy or sell. On the other hand, speculators use these contracts to bet on future price changes without necessarily having an interest in the underlying asset. This dual function helps stabilize prices and provides liquidity in the market, allowing both groups to engage effectively.
• Discuss the importance of margin requirements in futures trading and how they affect market participation.
  • Margin requirements are crucial in futures trading because they enable traders to control larger positions with a smaller amount of capital. This system of leveraging amplifies potential gains but also increases the risk of significant losses. As a result, margin requirements can attract more participants into the futures market, fostering greater liquidity while ensuring that traders maintain a certain level of collateral to back their positions.
• Evaluate how futures contracts influence price discovery and market efficiency within various asset classes.
  • Futures contracts play a significant role in price discovery by reflecting traders' collective expectations about future supply and demand for underlying assets. This process helps establish fair market prices based on available information and trading activity. Moreover, efficient futures markets contribute to overall market stability by providing signals that assist participants in making informed decisions regarding their investments across different asset classes, including commodities, currencies, and financial instruments.

Related terms

Hedging:

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

Options: Financial derivatives that give the buyer the right, but not the obligation, to buy or sell an asset at a predetermined price before a specified date.

Speculation: The practice of buying and selling financial instruments with the expectation of making a profit based on future price movements.