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Futures



Definition

Futures refer to a financial contract that obligates a buyer to purchase, and a seller to sell, a particular asset like a physical commodity or a financial instrument at a predetermined future date and price. They are used to manage the risk of price fluctuations by locking in a price for the asset in question. This financial derivative is traded on an exchange, with the terms standardized except for the price.

Phonetic

The phonetic pronunciation of the word “Futures” is: /ˈfjuːtʃərz/.

Key Takeaways

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  1. Futures are financial contracts obligating the buyer to purchase an asset or the seller to sell an asset at a predetermined future date and price.
  2. Futures contracts are used by companies as a hedge against fluctuations in market prices, providing them the ability to lock in the price of a commodity or security and reduce their risk of financial loss.
  3. While futures can be used for hedging against risk, they are also often used for speculative purposes by traders looking to profit from price changes in the asset underlying the futures contract.

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Importance

Futures are an essential concept in business and finance as they form the backbone of financial risk management. They are contractual agreements to buy or sell an asset–which could be a commodity, security, or financial instrument–at a predetermined price at a specific future date. The importance of futures lies primarily in their ability to hedge risk. By locking in a price today for a transaction that will occur in the future, it allows businesses and investors to mitigate the uncertainties of fluctuating prices. For instance, farmers can ensure a guaranteed selling price for their crops, while manufacturers can lock in an exact cost for necessary raw materials. This financial mechanism not only provides stability to the market but also increases liquidity and fosters accurate price discovery, making it a crucial foundation of modern finance.

Explanation

Futures are financial contracts that obligate the buyer to purchase an asset, or the seller to sell an asset, like a physical commodity or a financial instrument, at a predetermined future date and agreed-upon price. Futures contracts are used mainly to hedge or speculate on the future price of an asset. In other words, they create an agreement to buy or sell an asset in anticipation of future price changes. By locking in an asset price in advance, a business or investor can mitigate the risk of price fluctuations that might occur in the future. This hedging characteristic of futures is particularly useful in volatile markets, where price changes can be significant and unpredictable.Moreover, futures can be used for speculative reasons, where the participants agree to buy or sell the underlying asset to profit from price changes. Speculators, generally have no intention to own the underlying asset, but rather use futures to bet on price movements and seek financial gain from it. This function adds liquidity to the market, as it encourages more trading activity. In summary, while futures contracts can be used to mitigate risk (hedging), they can also be applied as tools of financial growth through speculation, serving different purposes according to investors’ strategies and objectives.

Examples

1. Agricultural Commodities: This is perhaps the most classic example of futures contracts. Here, farmers enter into these contracts to ensure a predetermined price for their crops. For instance, a wheat farmer may decide to sell futures contracts for his harvest in order to lock in a certain price. If the market price for wheat falls before the harvest, the farmer is protected because he has already guaranteed his price through the futures contract.2. Energy and Metals: Industries also use futures contracts to control costs and manage risk. Oil and gas companies, for example, use oil futures to lock in a price for their product, which helps them manage their operational budget and guard against the volatile swings in oil prices. Similarly, mining companies can sell futures contracts for gold, silver, and other metals to hedge their exposure to price fluctuations.3. Financial Markets: Financial futures are increasingly common in today’s global economy. These can involve agreements to buy or sell financial instruments, like bonds or stocks, at a future date. For example, a pension fund might use bond futures to manage its interest rate risk, while a mutual fund might use stock index futures to protect its portfolio against market downturns.

Frequently Asked Questions(FAQ)

What are futures?

Futures are financial contracts obligating 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.

How do futures contracts work?

Futures contracts detail the quality and quantity of the underlying asset; they are standardized to facilitate trading on a futures exchange. Parties commit to buy or sell the asset at a set price on a certain date in the future.

What types of assets can be purchased using futures?

Futures contracts are used to trade a wide range of assets. This includes commodities like oil, agricultural products or precious metals, financial instruments like government bonds or currencies, and indices.

Where are futures contracts traded?

Futures contracts are traded on a futures exchange, which acts as an intermediary between buyers and sellers. Some of the major futures exchanges include the Chicago Mercantile Exchange, the Intercontinental Exchange, and the New York Mercantile Exchange.

Who uses futures contracts and why?

Two main groups use futures contracts: hedgers and speculators. Hedgers use futures to reduce risk associated with fluctuating prices of an asset, while speculators aim to profit from changing prices.

What are the risks associated with futures?

Potential losses from futures contracts can exceed the initial investment, making it a risky investment strategy. This can occur if the value of the asset dramatically swings in the opposite direction than initially expected.

Are futures contracts standardized?

Yes, futures contracts are highly standardized, specifying the quantity of the commodity, delivery date, and location. This helps maintain liquidity in the market.

What happens if I hold a futures contract to maturity?

If you hold a futures contract to maturity, you would be obligated to deliver (if short) or take delivery (if long) of the underlying asset. However, most futures contracts are closed out before the delivery date.

Related Finance Terms

  • Derivatives
  • Commodities
  • Margins
  • Maturity Date
  • Contract Specifications

Sources for More Information


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