Futures

Definition

Futures are standardized financial contracts that obligate the buyer to purchase, and the seller to sell, a specified asset at a predetermined price on a specified future date. These contracts are commonly used to hedge against price fluctuations in underlying assets, such as commodities or financial instruments, making them an essential tool for managing financial risk.

5 Must Know Facts For Your Next Test

1. Futures contracts are traded on exchanges like the Chicago Mercantile Exchange (CME), ensuring standardized terms and liquidity.
2. They can be used for various assets including agricultural products, metals, energy products, and financial instruments like currencies and stock indices.
3. Market participants often use futures to lock in prices for buying or selling assets in order to manage potential losses from price volatility.
4. Futures require a margin deposit, which is typically a small percentage of the total contract value, allowing traders to control large positions with relatively little capital.
5. The settlement of futures contracts can occur through physical delivery of the asset or cash settlement, depending on the type of contract and agreement between parties.

Review Questions

• How do futures contracts serve as a tool for hedging against financial risk?
  • Futures contracts act as a hedge by allowing market participants to lock in prices for assets they intend to buy or sell in the future. For instance, if a farmer anticipates a drop in crop prices, he can sell futures contracts now to secure current prices, thus protecting himself from future price declines. This way, regardless of market fluctuations, the farmer can mitigate his financial risk.
• Compare and contrast futures and options in terms of their functions and uses in risk management.
  • Both futures and options are derivatives used in risk management but function differently. Futures obligate the buyer and seller to complete the transaction at the contract's expiration date, while options give the buyer the right without obligation. This means that futures can be more rigid but potentially more straightforward for hedging specific risks, while options provide flexibility at an additional cost. Their strategic use depends on the risk tolerance and market view of participants.
• Evaluate the impact of margin requirements on trading behavior and market volatility related to futures contracts.
  • Margin requirements play a crucial role in futures trading by allowing traders to leverage their positions. While this can amplify profits when markets move favorably, it also increases risk; if markets move against them, traders may face margin calls requiring additional funds. This dynamic can lead to increased market volatility as rapid shifts in prices may force traders to liquidate positions or add collateral. Thus, understanding margin is essential for assessing both individual trading strategies and overall market stability.

Related terms

Hedging: A risk management strategy that involves taking an offsetting position in a related asset to reduce the risk of adverse price movements.

Options: Financial derivatives that provide the buyer with the right, but not the obligation, to buy or sell an underlying asset at a specified price before a certain date.

Margin: The amount of money that must be deposited by a trader as collateral to open and maintain a futures position, which serves as a performance bond.