Futures

Definition

Futures are standardized financial contracts that obligate the buyer to purchase, and the seller to sell, a specific asset at a predetermined price on a specified future date. They are commonly used in financial markets as a way to hedge against price fluctuations in various commodities, currencies, or financial instruments.

5 Must Know Facts For Your Next Test

1. Futures contracts are traded on regulated exchanges, which provide transparency and standardized terms for buyers and sellers.
2. Both parties in a futures contract are required to meet margin requirements, which can change daily based on market movements.
3. Futures can be settled in cash or by physical delivery of the underlying asset, depending on the terms of the contract.
4. The price of futures contracts is influenced by various factors, including supply and demand dynamics, interest rates, and geopolitical events.
5. Traders use futures not only for hedging but also for speculative purposes, aiming to profit from price movements without the intention of actually taking delivery of the underlying asset.

Review Questions

• How do futures contracts help investors manage risk in their investment portfolios?
  • Futures contracts serve as a risk management tool by allowing investors to hedge against potential price fluctuations of underlying assets. By entering into a futures contract, an investor can lock in a price for an asset they intend to buy or sell in the future. This helps stabilize cash flows and protect against adverse market movements, making it easier for businesses and investors to plan and budget effectively.
• Discuss the role of margin requirements in trading futures and how they impact market dynamics.
  • Margin requirements play a crucial role in futures trading as they ensure that both parties have sufficient funds to cover potential losses. When traders enter a futures contract, they must deposit an initial margin with their broker, which acts as collateral. This not only helps mitigate counterparty risk but also influences market dynamics by impacting liquidity and leverage. Changes in margin requirements can lead to increased volatility if traders are forced to liquidate positions due to margin calls.
• Evaluate the implications of using futures for speculative purposes versus hedging and how this affects overall market stability.
  • Using futures for speculation can contribute to market volatility as speculators attempt to profit from short-term price movements, which may not reflect the fundamental values of underlying assets. While speculative trading can add liquidity to markets, it can also lead to excessive risk-taking and potential market distortions. On the other hand, hedging stabilizes prices for producers and consumers by mitigating risks associated with price fluctuations. The balance between speculative activities and hedging is critical for maintaining overall market stability and efficiency.

Related terms

Options: Options are financial derivatives that give the buyer the right, but not the obligation, to buy or sell an underlying asset at a specified price before a certain 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, often using derivatives like futures.

Margin: Margin refers to the collateral that an investor must deposit with a broker when trading futures, acting as a good faith deposit to cover potential losses.