Futures Contracts

Futures contracts are a type of derivative contract that allows market participants to buy or sell an underlying asset at a specified price and date in the future. Futures contracts are used to manage risk associated with fluctuations in prices and to provide liquidity to financial markets. In this article, we will provide an overview of futures contracts and their key features.

How Futures Contracts Work

Futures contracts are standardized contracts that are traded on exchanges. They specify the price at which the underlying asset will be bought or sold, as well as the delivery date of the asset. The underlying asset can be anything that is traded on the exchange, including commodities, currencies, and financial instruments such as stocks and bonds.

The price of a futures contract is determined by the supply and demand for the underlying asset, as well as other factors such as interest rates and storage costs. The price of the futures contract may differ from the current market price of the underlying asset, depending on market conditions and expectations.

Futures contracts are settled daily, meaning that gains and losses are credited or debited to the trader's account at the end of each trading day. This process is called marking-to-market.

Key Features of Futures Contracts

Standardization

Futures contracts are standardized, meaning that they have standardized terms and conditions that are set by the exchange. This makes it easy for traders to compare prices across different contracts and to trade with each other.

Margin Requirements

Futures contracts require margin, which is a deposit made by the trader to cover potential losses. The margin requirement is set by the exchange and varies depending on the volatility of the underlying asset.

Leverage

Futures contracts provide leverage, which allows traders to control a larger amount of the underlying asset with a smaller investment. This can amplify gains, but also increases the risk of losses.

Delivery

Futures contracts specify the delivery date of the underlying asset. However, most futures contracts are settled in cash, meaning that the underlying asset is not actually delivered. Instead, the trader receives or pays the difference between the contract price and the market price of the underlying asset at the time of settlement.

Benefits of Futures Contracts

Hedging

Futures contracts are commonly used for hedging, which involves using the futures contract to offset the risk of adverse price movements in the underlying asset. For example, a farmer might use a futures contract to lock in the price of a crop before it is harvested, to protect against price fluctuations.

Liquidity

Futures contracts provide liquidity to financial markets by allowing traders to buy and sell the underlying asset without actually owning it. This can increase market efficiency and reduce transaction costs.

Price Discovery

Futures contracts are used by traders to speculate on the future price of an underlying asset. This can lead to more accurate price discovery, as the collective actions of traders reflect market expectations and supply and demand for the underlying asset.

Limitations of Futures Contracts

Counterparty Risk

Futures contracts are subject to counterparty risk, which is the risk that the other party to the contract will default on their obligations. To mitigate this risk, exchanges require margin deposits and use clearinghouses to ensure that both parties fulfill their obligations.

Price Volatility

Futures contracts can be highly volatile, especially for assets with high price volatility. This can lead to large gains or losses for traders, and can also impact the broader financial markets.

Conclusion

Futures contracts are a valuable tool for managing risk and providing liquidity to financial markets. They provide traders with a way to buy and sell underlying assets without actually owning them, and can be used for hedging, speculation, and price discovery. However, futures contracts come with risks, including counterparty risk and price volatility, and should be used with caution by market participants.