Definition
A futures contract is a legally binding agreement between two parties to buy or sell an asset at a predetermined price at a specific future date. It’s extensively used in commodities trading but can be applied to any tradable asset. This contract is standardized in terms of quantity, quality, and delivery time and place, to facilitate trading on a futures exchange.
Key Takeaways
- A futures contract is a type of derivative financial agreement that obligates the buyer to purchase, and the seller to sell, an asset at a predetermined price and a specified time in the future.
- These contracts are standardized in terms of quality, quantity, delivery time and location, and are predominantly traded on exchanges. This makes them different from forward contracts which are private agreements between two parties.
- Futures contracts are used for hedging or speculative purposes. Hedgers use these contracts to mitigate the risk associated with price volatility of the asset, while speculators take advantage of this price volatility to potentially make a profit.
Importance
Futures Contracts are a cornerstone of financial risk management and play a vital role in the overall functioning of the global economy.
They are standardized agreements to buy or sell a specific commodity or financial instrument at a predetermined price at a set time in the future.
They provide a tool for producers, sellers, and financial institutions for hedging against potential price fluctuations and market volatility, thereby reducing financial risk.
Futures contracts can also be used for speculative investment purposes, allowing investors to potentially profit from predicted future price movements.
Their importance lies in their capacity to provide price certainty, improve market efficiency, and aid in the management of financial and commodity-based risks.
Explanation
A Futures Contract, predominantly in the financial markets, serves as a tool for mitigating risks and is an agreement to buy or sell commodities, securities, or other assets at a predetermined price at a specific time in the future. The primary purpose of a futures contract is to hedge positions and reduce the risk associated with adverse price movements in the asset.
For instance, producers can ensure they get a certain price for their product while consumers can secure their price for purchase. This risk management practice helps in stabilizing and providing predictability to both costs and revenues, helping businesses to plan ahead and maintain their financial stability even amid price fluctuations.
Additionally, Futures Contracts are also used for speculation, wherein traders bet on the direction in which asset prices will move. By so doing, market speculators, leveraging their trading strategies and financial acumen, aim to profit from the price changes of the underlying assets.
Although speculators take on significant risk, as potential losses could be substantial if the markets do not behave as predicted, the potential for higher returns attracts them to invest in futures contracts. Also, because of the significant role that Futures Contracts play in price discovery, they help in making widely accepted prices, which, in turn, contribute to overall market efficiency.
Examples of Futures Contract
Commodity Futures: Many agricultural producers use futures contracts to guarantee the sale price of their products. For instance, a wheat farmer may enter into a futures contract in the spring to sell 10,000 bushels of wheat at a specified price upon harvesting in the fall. This helps to protect the farmer from any potential drop in prices during the growth season.
Oil and Gas Futures: Oil companies, such as ExxonMobil or Shell, frequently use futures contracts to lock in a price for their oil. This provides them with a certain degree of financial stability. For example, an oil company might enter into a futures contract to sell 100,000 barrels of oil at $60 per barrel in six months. This ensures that they will receive this price even if the market price of oil drops during that period.
Currency Futures: International companies often use currency futures to hedge against unexpected changes in exchange rates. For instance, if an American company expects to receive payment in Euros three months from now, but is worried the Euro might depreciate in the meantime, they might buy a futures contract to lock in today’s exchange rate. This way, even if the Euro does lose value, the company is still protected.
Frequently Asked Questions about Futures Contract
What is a Futures Contract?
A futures contract is a legal agreement to buy or sell a particular asset at a predetermined price at a specified time in the future. The buyer is obliged to purchase the asset, and the seller to sell the asset when the future date arrives.
Where are Futures Contracts traded?
Futures contracts are traded on futures exchanges, which provides a marketplace for these financial instruments. Some of the world’s main futures exchanges are the Chicago Mercantile Exchange (CME), the Intercontinental Exchange (ICE), and the New York Mercantile Exchange (NYMEX).
What assets are typically involved in Futures Contracts?
Futures contracts can be used for a variety of assets such as commodities, stocks, currencies, interest rates and more. The most common examples include oil futures, gold futures, and stock index futures such as the S&P 500 futures.
What are the benefits of Futures Contracts?
Futures contracts can be used to hedge against potential price movements and to speculate on future price levels. This provides traders with a way to manage risk and take advantage of market opportunities. It is important to note that futures trading can also be complex and involves a significant amount of risk.
Who uses Futures Contracts?
Futures contracts are used by a wide variety of participants, including hedge funds, commodity producers and consumers, and individual traders. Some participants will use futures to hedge their business risks, while others use them to speculate on future price movements.
Related Entrepreneurship Terms
- Derivative
- Speculator
- Contract month
- Commodity futures
- Settlement price
Sources for More Information
- Investopedia: They offer comprehensive articles on many financial concepts, including Futures Contracts.
- Bloomberg: A key source for global financial information including details on Futures Contracts.
- Reuters: They provide financial market coverage, including topics on Futures Contracts.
- CME Group: This is the world’s leading and most diverse derivatives marketplace, providing detailed information on Futures Contracts.
