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Futures Contract



Definition

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. The buyer of the contract agrees to purchase the underlying asset when the contract expires, while the seller agrees to deliver the asset. This contract helps investors hedge against price volatility and speculate on price movements of the asset.

Phonetic

The phonetics of the term “Futures Contract” are: /’fjuːtʃərz ‘kɒntrækt/

Key Takeaways

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  1. Definition: 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. The buyer of the contract agrees to buy the underlying asset when the contract expires, while the seller agrees to provide it.
  2. Standardized Contracts: Futures contracts are standardized in terms of quality, quantity, and delivery time and location. This standardization makes futures contracts highly tradable and allows them to be used for hedging risk or for speculative purposes by traders.
  3. Risk Mitigation: Futures contracts can be effectively used as a tool to manage and mitigate price risk associated with volatility in the commodity or asset market. By locking in a price for future transaction, businesses can avoid potential losses from adverse price changes.

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Importance

Futures contracts are an integral part of the financial world because they allow businesses and investors to manage risk and organize financial planning. These contracts, which are agreements to buy or sell a particular commodity or financial instrument at a predetermined price at a specified time in the future, work as a form of financial insurance. For instance, producers can lock in a price for their products, protecting them from price fluctuations and enabling them to stabilize their revenues and costs. For investors, futures can provide a hedge against adverse price movements, an avenue for speculation, or an opportunity to gain price exposure to an asset without having to own it outright. In essence, futures contracts enhance market efficiency, increase economic stability, and contribute significantly to the smooth functioning of global financial markets.

Explanation

A futures contract serves a critical role in the financial ecosystem by allowing buyers and sellers to lock in the price of an asset or commodity for future delivery. It is a legally binding agreement entered into by two parties to buy or sell a specified amount of an asset at a predetermined price at a future date. This instrument is mainly used for hedging and speculation purposes. Hedging is a strategy used to minimize the risk of adverse price movements in the market, using futures contracts investors can shield themselves from volatile price swings by locking in a fixed price for a future transaction.For instance, a farmer growing wheat could sell a futures contract to deliver his crop at a future date for a price he locks in today. This way, he protects himself from potential price drops. Similarly, a company needing to buy a large volume of say, oil, in six months’ time could buy a futures contract at a predetermined price, thereby shielding itself from potential price hikes. On the other hand, futures contracts are also used for speculation where traders bet on the direction of prices to make a profit. They do this by trying to predict whether the price of an asset will rise or fall in the future and entering into futures contracts accordingly. Nevertheless, it’s important to note that, while speculation can yield high rewards, it also comes with significant risk.

Examples

1. Commodities Futures: A commonly used example of futures contracts in the real world is with commodities like oil or grains. Take the example an oil company enters into a futures contract with a drilling company. The oil company agrees to buy 100 barrels of oil from the drilling company in six months. The price is agreed upon upfront and is locked in – this means irrespective of whether the price of oil goes up or down in the market, the oil company will pay the agreed price to the drilling company.2. Agricultural Futures: Consider a farmer who is expecting his wheat crop to be ready for harvesting and selling in the market in about four months. However, he is uncertain about the price of wheat at that time. To hedge this risk, he enters into a futures contract with a wheat processor to sell a certain amount of wheat at a specific price in four months, ensuring that he will receive a guaranteed price.3. Stock Index Futures: Investors use futures contracts to hedge their equity positions against potential losses. For example, an investor who owns a large portfolio of European stocks might buy FTSE100 (UK stock index) futures contracts if he thinks the European markets will fall in value. If the actual market prices fall, the gain in value of the futures contracts will offset the loss in value of the European stocks, thus hedging the investor’s risk.

Frequently Asked Questions(FAQ)

What is a Futures Contract?

A futures contract is a legal agreement that obligates the buyer to purchase, and the seller to sell, a specific asset at a predetermined price and date in the future. This asset could be a physical commodity or a financial instrument.

What is the use of Futures Contracts?

Futures contracts are primarily used for hedging risks and for speculation. For example, investors can lock in prices to protect against future price changes, and traders can speculate on the future price of an asset.

What are the components of a Futures Contract?

A futures contract is composed of several key components including the type of asset, quantity of the asset, the delivery date, and the agreed-upon price.

Can you cancel a Futures Contract?

A futures contract cannot be cancelled , but it can be closed out or offset. This is done by taking an opposite position in the market, effectively neutralizing the obligations of the original contract.

Do Futures Contracts require an upfront payment?

Typically, futures contracts do not require full upfront payment. Instead, they require a margin, which is a small percentage of the contract’s total value. The margin works as a financial guarantee for the contract.

What is the difference between Futures and Forward Contracts?

The main difference between futures and forwards is that futures are traded on regulated exchanges, while forwards are traded over-the-counter (OTC) directly between two parties.

Why would a business use a futures contract?

A business might use a futures contract to lock in a price for a commodity they need for production, such as oil or grain, in order to manage risk and forecast costs.

What happens if the holder of a futures contract holds it until its expiration date?

If held until expiration, a futures contract will require the buyer to purchase and the seller to deliver the underlying asset at the agreed price, unless they enter into a closing transaction to cancel the obligations.

Related Finance Terms

  • Derivatives
  • Commodity Trading
  • Hedging
  • Contract Maturity
  • Spot Price

Sources for More Information


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