Futures contract

Definition

A futures contract is a standardized legal agreement to buy or sell an asset at a predetermined price at a specified time in the future. These contracts are traded on exchanges, which helps ensure liquidity and price discovery, making them essential tools for hedging risks and speculating on price movements in various markets.

5 Must Know Facts For Your Next Test

1. Futures contracts are standardized, meaning they specify the quantity and quality of the underlying asset, ensuring uniformity across trades.
2. They are traded on regulated exchanges, which reduces counterparty risk compared to over-the-counter agreements, where parties negotiate terms privately.
3. Futures contracts can be settled either through physical delivery of the asset or cash settlement, depending on the terms agreed upon by the parties.
4. These contracts are commonly used for commodities like oil and wheat, as well as financial instruments like currencies and stock indices.
5. Traders often use leverage when trading futures contracts, allowing them to control large positions with a smaller amount of capital, which can amplify both gains and losses.

Review Questions

• How do futures contracts differ from options contracts in terms of obligations and rights?
  • Futures contracts involve an obligation for both parties to buy and sell the underlying asset at the agreed-upon price at expiration. In contrast, options contracts provide the holder with the right, but not the obligation, to buy or sell the underlying asset. This means that with futures, both parties must fulfill their side of the deal at expiration, while options allow flexibility since the holder can choose whether or not to execute the contract.
• Discuss the importance of margin in futures trading and how it impacts traders' strategies.
  • Margin plays a critical role in futures trading as it serves as collateral that traders must deposit to open and maintain their positions. This requirement enables traders to leverage their investments, controlling larger positions than their initial capital would allow. However, it also introduces risks; if a trader's position moves against them significantly, they may face a margin call, requiring them to deposit more funds or liquidate positions to cover losses.
• Evaluate how futures contracts can be utilized for hedging purposes and provide examples of their application in real-world scenarios.
  • Futures contracts are widely used for hedging against price fluctuations in various markets. For example, a farmer expecting to harvest wheat in three months might sell wheat futures contracts today to lock in current prices, protecting themselves from potential declines. Similarly, airlines might use fuel futures to hedge against rising oil prices, ensuring predictable fuel costs despite market volatility. This risk management tool allows businesses to stabilize their financial performance amid uncertain market conditions.

Related terms

options contract: An options contract gives the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before or at a specified expiration date.

hedging: Hedging is a risk management strategy used to offset potential losses in an investment by taking an opposite position in a related asset, such as using futures contracts to protect against price fluctuations.

margin: Margin refers to the collateral that an investor must deposit to open and maintain a futures position, which acts as a security for both parties involved in the contract.