Futures Contract

Published Apr 29, 2024

Definition of Futures Contract

A futures contract is a standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future. The assets often traded in futures contracts include commodities, currencies, and financial instruments. Futures contracts detail the quantity of the asset and are used by both hedgers and speculators. Hedgers use futures to lock in prices to stabilize the costs or revenues of their business operations, while speculators aim to profit from price movements of the underlying asset.

Example

Consider a farmer who plants wheat and expects to harvest and sell his crop in six months. The farmer worries that the price of wheat might decline by the time he harvests his crop. To protect against this risk, the farmer can enter into a futures contract to sell his anticipated wheat at a fixed price at harvest time. If the market price of wheat falls below this fixed price, the farmer is protected against the loss because he has locked in a higher selling price through the futures contract.

Conversely, a bread manufacturer might use futures contracts to lock in the price of wheat they will need in the future. This way, if wheat prices rise, the manufacturer is protected against higher costs because they have secured a lower purchase price through the futures contract.

Why Futures Contracts Matter

Futures contracts are vital financial instruments that facilitate the risk management of price volatility in essential commodities and other assets. By allowing parties to lock in prices, they can plan and budget more efficiently, reducing the uncertainty that price fluctuations bring to their operations. Additionally, futures markets provide a mechanism for price discovery, reflecting the market’s expectations regarding future supply and demand conditions. Speculators in these markets can also add liquidity, making it easier for others to open and close positions as needed.

Frequently Asked Questions (FAQ)

What distinguishes a futures contract from a forward contract?

While both futures and forward contracts are agreements to buy or sell an asset at a future date, the key difference lies in their standardization and trading venues. Futures contracts are traded on exchanges, making them standardized agreements with cleared through a clearinghouse, which reduces credit risk. In contrast, forward contracts are private agreements between parties, customized to their specific needs, and typically carry more counterparty risk since they are not cleared through a clearinghouse.

Can you lose money in futures trading?

Yes, trading in futures can result in substantial losses, especially for speculators. The leverage used in futures trading means that small market movements can lead to significant gains or losses relative to the initial margin. Losses can exceed the initial investment if the market moves unfavorably. Hence, it’s crucial for traders to have risk management strategies in place.

How are futures contracts settled?

Futures contracts can be settled in two ways: physical delivery or cash settlement. In physical delivery, the underlying asset is physically delivered from the seller to the buyer on the contract’s expiry. In cash settlement, no physical delivery occurs; instead, the difference between the future contract price and the spot price of the underlying asset is exchanged. The settlement method depends on the specific contract and the nature of the traded asset.

What role do speculators play in the futures market?

Speculators are market participants who seek to profit from price fluctuations of futures contracts. They do not intend to take delivery of the physical commodity. Speculators provide liquidity to the market, making it easier for hedgers to open and close their positions. While often viewed critically, speculators’ trading activities contribute to the price discovery process, reflecting the market’s collective expectations concerning future price movements.

Futures contracts represent a critical component of the global financial system by allowing companies and individuals to hedge against price risks and by providing mechanisms for price discovery and investment opportunities. Their complexity and the risks involved necessitate a deep understanding of their operation, benefits, and potential pitfalls.