Futures Contracts

Definition

A futures contract is a legal agreement to buy or sell a particular commodity or financial instrument at a predetermined price at a specified time in the future. These contracts are standardized and traded on organized exchanges, allowing investors to manage price risk associated with the underlying asset.

5 Must Know Facts For Your Next Test

1. Futures contracts allow traders to speculate on the future price of an asset, providing a way to manage price risk and uncertainty.
2. The standardized nature of futures contracts, including the quantity, quality, and delivery date, facilitates trading on organized exchanges.
3. Futures markets provide price discovery, allowing market participants to determine the fair value of the underlying asset based on supply and demand.
4. Margin requirements and daily settlement (marking to market) are essential features of futures trading, ensuring the integrity of the market.
5. Futures contracts can be used for hedging, where a party with an existing position in the underlying asset takes an offsetting position to mitigate the risk of adverse price movements.

Review Questions

• Explain how futures contracts can be used to manage price risk in the foreign exchange market.
  • In the foreign exchange market, participants can use currency futures contracts to hedge against fluctuations in exchange rates. By taking an offsetting position in a futures contract, they can lock in a predetermined exchange rate for a future transaction, effectively protecting themselves from adverse currency movements. This allows businesses and investors to manage their foreign exchange exposure and reduce uncertainty in their financial planning and decision-making.
• Describe the role of futures contracts in the price discovery process within the foreign exchange market.
  • Futures contracts traded on organized exchanges, such as currency futures, contribute to the price discovery process in the foreign exchange market. The continuous trading and interaction of buyers and sellers in the futures market helps to determine the fair value of currencies based on supply and demand. This price discovery function provides a benchmark for spot foreign exchange rates and helps market participants make informed decisions about their currency exposures and transactions.
• Analyze how the standardized features of futures contracts, such as quantity and delivery date, facilitate trading and risk management in the foreign exchange market.
  • The standardized nature of futures contracts, including the predetermined quantity of the underlying asset and the specified delivery date, enables efficient trading and risk management in the foreign exchange market. This standardization allows for the creation of a centralized and liquid market, where participants can easily enter and exit positions, as well as effectively hedge their currency exposures. The standardized contract terms also promote transparency, price discovery, and the ability to compare and assess different trading opportunities, enhancing the overall functioning and efficiency of the foreign exchange market.

Related terms

Commodity Futures: Futures contracts that are based on physical commodities such as agricultural products, metals, or energy resources.

Financial Futures: Futures contracts that are based on financial instruments like currencies, interest rates, or stock indexes.

Hedging:

The practice of taking an offsetting position in a futures contract to reduce the risk of adverse price movements in the underlying asset.