Futures Contracts

Definition

A futures contract is a legally binding agreement to buy or sell an asset at a predetermined price at a specified future date. These contracts are standardized and traded on exchanges, allowing participants to hedge against price fluctuations in various assets, including currencies, commodities, and financial instruments, thus playing a critical role in managing exchange rate risk.

5 Must Know Facts For Your Next Test

1. Futures contracts are standardized in terms of quantity, quality, and delivery time, which helps facilitate trading on exchanges.
2. They can be used to hedge against potential losses due to unfavorable price movements in the underlying asset, providing stability in financial planning.
3. Participants can either be hedgers, who seek to reduce risk, or speculators, who aim to profit from price changes in the market.
4. The use of margin in futures trading allows participants to control larger positions than their initial investment, increasing both potential profits and risks.
5. Futures contracts settle either through physical delivery of the underlying asset or cash settlement, depending on the terms of the contract.

Review Questions

• How do futures contracts serve as a hedging technique against exchange rate risk?
  • Futures contracts allow companies and investors to lock in exchange rates for currencies they will need in the future. By entering into these contracts, they can protect themselves from potential adverse movements in currency values. For example, if a U.S. company expects to receive payment in euros six months from now, it can sell euro futures contracts to ensure that it receives a specific dollar amount regardless of fluctuations in the euro's value.
• Discuss how futures contracts differ from other financial instruments used for hedging exchange rate risk.
  • Futures contracts differ from options and forward contracts primarily in their standardization and trading mechanism. While options give the holder the right but not the obligation to buy or sell an asset, futures obligate both parties to complete the transaction. Forward contracts are customizable agreements between two parties but are not traded on exchanges, making them less liquid. The standardized nature of futures makes them more accessible and transparent for hedging purposes compared to these other instruments.
• Evaluate the implications of using futures contracts for businesses engaged in international trade and how it affects their risk management strategies.
  • Using futures contracts for international trade significantly enhances a business's risk management strategy by providing a tool to lock in prices and protect against currency volatility. This proactive approach helps stabilize cash flows and enables more accurate budgeting and forecasting. However, it also requires careful monitoring of market conditions and potential margin calls, which can introduce additional financial pressure if not managed effectively. Ultimately, successful use of futures contracts can lead to improved competitiveness and profitability in global markets.

Related terms

Hedging: Hedging involves taking an offsetting position in a related asset to mitigate potential losses from fluctuations in the price of an asset.

Speculation: Speculation refers to the practice of buying and selling assets with the expectation of making a profit from price changes rather than using them for their intended purpose.

Margin: Margin is the collateral that an investor must deposit with a broker to cover some or all of the credit risk the broker takes on by allowing the investor to trade futures contracts.