Futures Contracts

1. Definition and Purpose

• What Are Futures Contracts?

  • A futures contract is a standardized financial agreement between two parties to buy or sell a specific asset (the underlying) at a predetermined price (the futures price) on a specified future date.

  • These contracts facilitate risk management, speculation, and investment by allowing participants to hedge against price fluctuations or profit from anticipated market movements.

• Purpose of Futures Contracts:

  • Risk Hedging: Businesses and investors use futures contracts to mitigate price risk. For example:

    • Commodity Producers: Farmers can lock in prices for their crops before harvest to protect against price declines.

    • Manufacturers: Companies can secure raw material prices to avoid supply chain disruptions.

    • Currency Traders: Hedging against foreign exchange rate fluctuations.

  • Speculation: Traders speculate on price movements without intending to take physical delivery of the underlying asset.

  • Investment: Some investors use futures contracts as part of their portfolio diversification strategy.

2. Types of Futures Contracts

1. Commodity Futures:

   • These involve physical commodities such as:

     • Agricultural products (wheat, corn, soybeans).

     • Energy resources (crude oil, natural gas).

     • Metals (gold, silver, copper).

   • Commodity futures allow producers, consumers, and traders to manage price risk.

2. Financial Futures:

   • These relate to financial instruments:

     • Interest Rate Futures: Based on interest rates (e.g., Treasury bonds, Eurodollar futures).

     • Stock Index Futures: Linked to stock market indices (e.g., S&P 500, NASDAQ).

     • Currency Futures: Tied to exchange rates (e.g., EUR/USD, JPY/USD).

   • Financial futures provide exposure to broader market movements.

3. Index Futures:

   • These track specific stock market indices (e.g., S&P 500, Dow Jones Industrial Average).

   • Investors use index futures for portfolio diversification and to speculate on overall market trends.

4. Single-Stock Futures:

   • These focus on individual stocks.

   • Traders can speculate on the price movement of a specific company’s stock.

3. Key Takeaways

• Leverage: Futures contracts allow traders to control a large position with a relatively small initial margin.

• Expiration and Rollover: Contracts have fixed expiration dates, and traders must roll over positions if they wish to maintain exposure.

• Marking to Market: Daily settlement of gains or losses ensures transparency.

• Delivery vs. Cash Settlement: Most futures contracts are cash-settled, meaning no physical delivery occurs.