Futures

Definition

Futures are standardized contracts that obligate the buyer to purchase, and the seller to sell, a specific asset at a predetermined price at a specified future date. These contracts are traded on exchanges and can involve various assets, including commodities, currencies, and financial instruments, making them a crucial part of financial markets. Futures provide a mechanism for price discovery and risk management, allowing participants to hedge against price fluctuations or speculate on future price movements.

5 Must Know Facts For Your Next Test

1. Futures contracts are traded on exchanges like the Chicago Mercantile Exchange (CME) and are standardized in terms of quantity and quality of the underlying asset.
2. They can be used by producers and consumers of commodities to lock in prices, ensuring they are protected against adverse price movements.
3. Speculators use futures to profit from price changes without the need to own the actual underlying asset.
4. The pricing of futures contracts is influenced by factors such as interest rates, storage costs, and the supply and demand dynamics of the underlying asset.
5. Mark-to-market is a process that adjusts the margin accounts of futures traders based on daily price changes, ensuring that gains and losses are settled regularly.

Review Questions

• How do futures contracts facilitate risk management for businesses dealing with commodity prices?
  • Futures contracts allow businesses that rely on commodities to manage their exposure to price fluctuations by locking in prices for future delivery. For instance, a farmer can sell futures contracts for their crop before harvest, securing a guaranteed price regardless of market conditions at that time. This hedging strategy helps stabilize cash flow and reduces uncertainty in budgeting and financial planning.
• Discuss how futures trading contributes to price discovery in financial markets.
  • Futures trading plays a vital role in price discovery by providing a platform where buyers and sellers come together to agree on future prices based on supply and demand expectations. The active trading of these contracts reflects market sentiment and expectations about future price movements, helping investors make informed decisions. As more participants engage in futures trading, it leads to more accurate pricing of the underlying assets in real-time.
• Evaluate the implications of margin requirements on the behavior of futures traders and overall market stability.
  • Margin requirements influence futures traders' behavior by determining how much capital they need to commit for their positions. Low margin requirements can lead to increased speculation as traders leverage their positions, amplifying both potential gains and losses. While this can enhance market liquidity and trading volume, it may also pose risks to market stability, particularly during periods of high volatility when sudden price swings can trigger margin calls, leading to forced liquidations and exacerbating market downturns.

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 predetermined price before a specified expiration date.

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

Margin: Margin refers to the collateral that an investor must deposit with their broker when trading futures contracts, which serves as a guarantee for the transaction.