Futures contracts

Table of Contents

Futures contracts
What is a futures contract?
Understanding futures contracts
Types of futures contracts
Uses of futures contract
Examples of a futures contract
Frequently Asked Questions

Futures contracts

Futures contracts are financial derivatives that obligate the buyer to purchase and the seller to sell a specified quantity of a particular asset (usually a commodity or a financial instrument) at a pre–determined price on a specified future date. These contracts are standardised in terms of contract size, expiration date, and other terms, making them highly liquid and tradable on organised exchanges.

What is a futures contract?

A futures contract is a financial arrangement between two parties to purchase or sell a given quantity of an underlying asset at a defined price on a specific future date. These parties are called the buyer (long position) and the seller (short position). These contracts are crucial to the world’s financial markets since they are standardised and exchanged on established exchanges.

Understanding futures contracts

Futures contracts serve several purposes:

Price discovery

Futures contracts assist in determining a fair market price for the underlying asset, reflecting the general agreement of market participants regarding its potential worth in the future.

Risk management

They offer a way to protect against price changes. To safeguard against prospective price decreases, a farmer, for instance, might utilise futures to lock in a price for his products.

Speculation

Traders utilise futures contracts without holding the underlying asset to profit from price changes.

Types of futures contracts

Futures contracts can be categorised into various types based on the underlying asset:

Commodity futures contracts

These are contracts based on commodities like gold, oil, agricultural products, and more. Commodity futures are essential for producers and consumers to manage price risks.

Financial futures contracts

Financial instruments like stock indices, interest rates, and foreign currencies are commonly associated with these contracts. They are often used for hedging and speculative purposes.

Currency futures contracts

Currency futures involve the exchange of one currency for another at a future date and a predetermined exchange rate. They are crucial for managing exchange rate risks.

Stock futures contracts

These contracts represent an eagerness to buy or sell a number of a particular stock at a future date. They allow investors to speculate on stock price movements.

Interest rate futures contracts

These contracts are based on assets that provide interest, such as government bonds. They are essential for controlling interest rate risk since they are utilised as a hedge against interest rate swings.

Stock index futures contracts

They monitor the trend of stock market indices like the Dow Jones Industrial Average or NASDAQ-100. Investors utilise these contracts to control portfolio risk and engage in market speculation.

Uses of futures contract

Futures contracts perform several crucial tasks in the financial markets, including:

Hedging

Protecting against price volatility is one of the main purposes of futures contracts. They serve as a form of protection for investors and businesses from unfavourable changes in the price of various assets.

Speculation

To benefit from price swings, traders and investors participate in speculative trading. They can make predictions about the movement of asset values by placing positions in futures contracts.

Arbitrage

Arbitrageurs profit from price differences between the spot and futures markets. They try to achieve a risk-free profit by purchasing in the less costly market and selling in the more expensive one.

Price analysis

Futures markets offer a clear context for estimating asset prices in the future, which aids in establishing fair market values.

Liquidity

Futures contracts boost market liquidity by making acquiring and selling assets easier.

Examples of a futures contract

Here are a few real-world examples of futures contracts:

Futures contracts in agriculture: A wheat farmer can sign a futures contract to sell a specific amount of wheat at a fixed price, guaranteeing a steady income regardless of changes in market prices.

Interest rate futures

To protect its bond portfolio against possible losses, a bank concerned about increasing interest rates may utilise interest rate futures.

Stock index futures

An investor anticipating a gain in the stock market may purchase stock index futures contracts to benefit from the market’s success.

Currency futures

To secure a favourable exchange rate for a future transaction, a multinational firm exposed to a currency exchange rate concerns might employ currency futures.

Frequently Asked Questions

What are the mechanics of futures contracts?

Futures contracts involve several key components:

Contract specifications

These define the underlying asset, contract size, expiration date, and other terms.

Clearinghouse

A central clearinghouse acts as an intermediary, ensuring contract obligations are met and mitigating counterparty risk.

Margin

Both parties must maintain margin accounts, providing collateral to cover potential losses.

Mark-to-market

The contract’s value is adjusted daily based on market prices, and gains or losses are settled daily.

What are the 4 types of futures contracts?

The four main types of futures contracts are commodity futures, financial futures, currency futures, and stock futures.

How to trade futures?

Follow these steps to trade futures:

Create a brokerage account on a platform for trading futures.
Choose the precise futures contract you wish to trade after doing your research.
Analyse market trends to decide on your trading strategy.
Place an order emphasising the contract, the amount, and the cost.
You can monitor your position and limit your risk by placing stop-loss and take-profit orders.
If you desire physical delivery, close your position by offsetting the contract before it expires or by letting it expire.
Acknowledge the risks and leverage involved with trading futures.

Are futures a type of derivative?

Yes, futures deals are derivative because their value is derived from the underlying asset’s price. Options, swaps, and forwards are other typical derivatives included in the larger financial derivatives category since they all derive their worth from a financial metric or underlying asset.

What happens if you hold a futures contract until expiration?

If you hold a futures contract until expiration:

For physically settled contracts (e.g., commodity futures), you may be required to deliver or take delivery of the underlying asset.
For cash-settled contracts (e.g., stock index futures), the contract settles in cash, with gains or losses realised based on the difference between the contract’s final price and the entry price.

The futures contracts are essential instruments in the world of finance, serving as tools for risk management, price discovery, speculation, and more. Understanding how futures contracts work and their various applications is crucial for participants in financial markets.