Definition
Futures, in finance, are a standardized legal agreement to buy or sell something at a predetermined price at a specified time in the future. This “something” can be a physical commodity, like grain, or a financial instrument, like a government security. Generally used for hedging or speculation purposes, futures are traded on a futures exchange, which acts as an intermediary.
Key Takeaways
- The finance term “Futures” refers to a financial contract obliging the buyer to purchase an asset (or the seller to sell an asset), such as a physical commodity or a financial instrument, at a predetermined future date and price.
- Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Some futures contracts may call for physical delivery of the asset, while others are settled in cash.
- The primary purpose of futures is to hedge risk or speculate on the price direction of the underlying asset. The risk lies in the possibility of the price moving against the position taken, either hedging risk or speculating.
Importance
Futures are important in finance as they allow investors and businesses to lock in the price of the assets they trade, enabling them to manage risk or speculate on the future price of assets.
This concept allows participants in industries such as agriculture, oil, and financial services to plan for the future with more certainty, as they can secure their budget and protect against potentially disastrous price swings.
Moreover, futures contracts also provide opportunities for traders to profit from market volatility, which can yield significant financial rewards for investors who correctly predict the future price movement of an asset.
Therefore, futures contracts aid in market stability and in fostering an efficient, forward-looking financial market.
Explanation
Futures, as a financial tool, are derivative contracts primarily used for two key purposes: hedging and speculation. Hedging with futures is an approach used by companies and investors to reduce or mitigate the risk of price fluctuations on commodities, securities, or a specific financial instrument.
For instance, a corn farmer could sell futures contracts for his crop to lock in a specific price and prevent loss in case corn prices decline in the coming months. By doing so, they secure their earnings and protect themselves from potential changes in the market.
On the other hand, futures are also utilized for speculation, where traders attempt to profit from price fluctuations. For speculators, futures contracts provide an opportunity to bet on the ways they believe market prices will move.
They buy futures contracts if they anticipate prices will rise (going long), or sell if they expect prices to fall (going short). It’s important to note that this kind of trading is risky because it largely depends on market predictions. Futures are an effective mechanism for price discovery and risk management, serving as a key component in the financial marketplace.
Examples of Futures
Agricultural Futures: One of the oldest examples of futures is in the farming industry. Farmers use futures contracts to lock in a price for their crops ahead of the harvest season. By doing this, they aim to protect themselves from potential price drops. For instance, a wheat farmer might enter into a futures contract in the spring, agreeing to sell 5000 bushels of wheat at $5 per bushel in September. If the price per bushel falls to $4 by September, the farmer still gets to sell his wheat for $5 per bushel, as stated in the futures contract.
Energy Futures: Energy companies commonly use futures to manage price risk associated with fluctuations in the price of oil, natural gas, and other energy sources. For instance, an oil company might agree to sell a specified amount of crude oil at $60 per barrel six months from today. If oil prices tumble, the company is still guaranteed the price stated in the futures contract, thereby protecting its revenue.
Currency Futures: Businesses that operate internationally often use futures to hedge against potential losses from fluctuating exchange rates. A US-based company planning to purchase supplies from Europe in six months might buy a futures contract for a predetermined amount of Euros. This way, even if the value of the Euro increases against the dollar over the next six months, the company will not have to pay more than the rate specified in the futures contract.
Frequently Asked Questions about Futures
What are Futures?
A Futures contract is a legal agreement to buy or sell a particular commodity or asset at a predetermined price at a specified time in the future. Futures contracts are often used by investors to hedge against price risk.
How do Futures work?
Future contracts work by providing a contract to both the buyer and seller for the purchase/sale of an asset at a future date. The price is agreed upon at the time of the contract. On the due date, the buyer pays the agreed price and the seller delivers the asset.
What are the types of Futures contracts?
There are two main types of futures contracts: Commodity futures and Financial futures. Commodity futures are contracts on commodities like gold, oil, natural gas etc. Financial futures are contracts on financial instruments like currency, bonds, and market index.
What are the risks associated with Futures?
The primary risk associated with futures is market risk – as the value of the underlying asset changes, so too does the value of the futures contract. There is also execution risk, as the buyer must be able to purchase the asset and the seller must be able to deliver the asset on the delivery date.
Are Futures regulated?
Yes, futures contracts are regulated by regulatory bodies like the Commodity Futures Trading Commission in the United States. Different countries have their own regulatory bodies to oversee the futures markets.
Related Entrepreneurship Terms
- Derivatives
- Commodity Futures Trading Commission (CFTC)
- Margins
- Contract Size
- Expiration Date
Sources for More Information
- Investopedia: It’s one of the most visited websites for comprehensive and understandable content on a broad range of financial topics.
- CBOE: Chicago Board Options Exchange (CBOE) is the world’s largest options exchange & it provides informative resources about futures and other financial products.
- Reuters: It’s a leading source of finance market news and it covers a variety of topics including futures.
- Bloomberg: Provides top-notch quality resources about finance, futures contracts, and more.
