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 commonly used in financial markets to hedge against price fluctuations and are linked closely with benchmark rates like LIBOR, influencing the cost of borrowing and investment decisions.

5 Must Know Facts For Your Next Test

1. Futures contracts can be traded on various exchanges, allowing for liquidity and price discovery in the market.
2. They cover a wide range of assets, including commodities, currencies, and financial instruments, making them versatile tools for investors.
3. The settlement of futures contracts can occur either through physical delivery of the asset or cash settlement, depending on the terms agreed upon.
4. Futures prices are influenced by various factors, including supply and demand dynamics, economic indicators, and changes in benchmark interest rates like LIBOR.
5. Market participants use futures contracts not only for hedging but also for speculation, aiming to profit from price movements in the underlying assets.

Review Questions

• How do futures contracts serve as a tool for hedging against price fluctuations in financial markets?
  • Futures contracts allow market participants to lock in prices for assets, helping them protect against unexpected price movements. For example, a farmer can sell futures contracts for their crop at harvest time, ensuring they receive a specific price regardless of market fluctuations. This mechanism effectively stabilizes income and reduces the financial risk associated with volatile markets.
• Discuss how benchmark rates like LIBOR impact the pricing of futures contracts and overall market dynamics.
  • Benchmark rates like LIBOR play a crucial role in determining the cost of borrowing and thus influence the pricing of futures contracts. A rise in LIBOR may lead to higher costs for maintaining positions in these contracts, potentially affecting supply and demand dynamics. Traders often consider these rates when formulating their strategies, as they impact interest rate expectations and can cause shifts in market sentiment towards certain assets.
• Evaluate the significance of margin requirements in futures trading and their implications for market stability.
  • Margin requirements are essential in futures trading as they ensure that traders have sufficient capital to cover potential losses. By requiring a deposit before entering a contract, it helps mitigate the risk of default and promotes market stability. High volatility can lead to margin calls, where traders must deposit additional funds to maintain their positions. This mechanism prevents excessive speculation and helps maintain orderly markets during turbulent times.

Related terms

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

Spot Price: The current market price at which an asset can be bought or sold for immediate delivery.

Margin Requirement: The minimum amount of funds that must be deposited with a broker when entering into a futures contract, serving as collateral against potential losses.