Futures contracts

Definition

Futures contracts are legally binding agreements to buy or sell a specific asset at a predetermined price on a specified future date. These contracts are used primarily for hedging and speculation, allowing parties to manage price risk associated with commodities, currencies, and financial instruments. Futures contracts play a crucial role in the financial services sector by providing liquidity and price discovery in various markets.

5 Must Know Facts For Your Next Test

1. Futures contracts can be traded on regulated exchanges or over-the-counter, giving flexibility in how they are utilized.
2. These contracts standardize the quantity and quality of the underlying asset, which helps facilitate smoother transactions.
3. Participants in futures markets include hedgers, who use contracts to mitigate risk, and speculators, who aim to profit from price fluctuations.
4. Futures contracts often require a margin deposit, which is a fraction of the total contract value, allowing traders to leverage their positions.
5. Settlement of futures contracts can occur either through physical delivery of the asset or cash settlement, depending on the terms specified.

Review Questions

• How do futures contracts help investors manage risk in financial markets?
  • Futures contracts allow investors to hedge against potential price fluctuations in assets they own or plan to purchase. By locking in prices for future transactions, investors can protect themselves from adverse market movements. This risk management tool is particularly useful for businesses reliant on commodity prices, as it enables them to stabilize costs and budget more effectively.
• Discuss the difference between hedging and speculation in the context of futures contracts.
  • Hedging involves using futures contracts to protect against potential losses in an underlying asset by taking a position that offsets risks. For example, a farmer may sell futures contracts for their crop to lock in prices before harvest. In contrast, speculation involves taking positions in futures markets with the hope of profiting from anticipated price changes without necessarily holding the underlying asset. Speculators contribute to market liquidity but also introduce additional volatility.
• Evaluate the implications of margin requirements for traders in futures markets and how this affects their risk exposure.
  • Margin requirements in futures trading enable traders to control larger positions than they could with their available capital alone, thereby increasing potential returns. However, this leverage also amplifies risk; if market prices move unfavorably, traders may face margin calls requiring them to deposit additional funds or close positions at a loss. This dynamic creates a need for careful risk management strategies among traders to avoid significant financial exposure.

Related terms

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

Speculation: The practice of buying and selling financial instruments with the expectation of making a profit based on future price movements.

Margin: The collateral required by an exchange to cover potential losses in futures trading, ensuring that both parties fulfill their contractual obligations.