Futures

Definition

Futures are financial contracts that obligate the buyer to purchase, and the seller to sell, a specific asset at a predetermined price at a specified future date. They play a crucial role in managing foreign exchange exposure and risk by allowing businesses to lock in exchange rates, providing certainty and stability against currency fluctuations.

5 Must Know Facts For Your Next Test

1. Futures contracts can be traded on exchanges, making them standardized and accessible for various commodities and financial instruments.
2. They are commonly used by businesses involved in international trade to manage risks associated with fluctuating currency exchange rates.
3. When using futures for hedging, the goal is to minimize potential losses due to adverse price movements in the underlying asset.
4. The margin requirement for futures trading ensures that both parties maintain a certain level of capital to cover potential losses, reducing counterparty risk.
5. Futures markets are often used by speculators who aim to profit from changes in prices, making them more volatile compared to traditional investment vehicles.

Review Questions

• How do futures contracts help businesses manage foreign exchange exposure?
  • Futures contracts help businesses manage foreign exchange exposure by allowing them to lock in exchange rates for future transactions. By entering into a futures contract, a company can secure a specific rate today for a currency they will need at a later date. This helps mitigate the risks associated with currency fluctuations, ensuring that the cost of goods or services remains predictable regardless of market changes.
• In what ways do futures differ from forward contracts in terms of usage and trading environment?
  • Futures contracts differ from forward contracts primarily in their trading environment and standardization. Futures are traded on organized exchanges, which means they are standardized in terms of contract size and expiration dates. In contrast, forward contracts are customized agreements that trade over-the-counter between two parties. This means forwards can be tailored to specific needs but come with higher counterparty risk due to the lack of regulation and standardization.
• Evaluate the impact of speculation on futures markets and its implications for businesses using these contracts to hedge foreign exchange risk.
  • Speculation can significantly impact futures markets by increasing volatility and influencing price movements. When speculators buy or sell large volumes of futures contracts based on their predictions about currency movements, it can lead to rapid price changes that may affect businesses looking to hedge their foreign exchange risk. While hedgers aim for stability by locking in prices, speculative activities can create unpredictable conditions that complicate their risk management strategies. Therefore, businesses must be aware of market dynamics influenced by speculation when utilizing futures for hedging purposes.

Related terms

Hedging: Hedging is a risk management strategy used to offset potential losses in investments, typically through derivatives like futures or options.

Forward Contracts: Forward contracts are customized agreements between two parties to buy or sell an asset at a specified price on a future date, similar to futures but traded over-the-counter.

Speculation: Speculation involves buying or selling financial instruments with the expectation of making a profit from future price movements, often using futures as a tool.