Futures Contract

A futures contract is a standardized, legally binding agreement between two parties to buy or sell a specific asset, such as a commodity, financial instrument, or currency, at a predetermined price (called the "strike price" or "futures price") and at a specified future date (the "expiration date" or "delivery date"). Futures contracts are traded on organized exchanges, such as the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (NYMEX).

Futures contracts serve several purposes, including:

1. Hedging: Market participants, such as producers, consumers, and investors, can use futures contracts to hedge against the risk of adverse price movements in the underlying asset. For example, a farmer can sell a futures contract on their crop to lock in a specific price, protecting them from the risk of falling prices before the crop is harvested.
2. Speculation: Traders and investors can use futures contracts to speculate on the future price movements of the underlying assets, aiming to profit from price changes without having to own the underlying asset. If a trader believes that the price of an asset will rise in the future, they can buy a futures contract, while if they believe that the price will fall, they can sell a futures contract.
3. Price discovery: Futures markets provide valuable information about market participants' expectations of future prices, which helps in the price discovery process. The prices of futures contracts can serve as a reference for pricing the underlying asset in the spot market.

Key components of a futures contract:

1. Underlying asset: The asset that is the subject of the contract, such as a commodity (e.g., oil, gold, wheat), a financial instrument (e.g., a stock index, a bond), or a currency.
2. Contract size: The standardized quantity of the underlying asset that the contract represents. For example, a gold futures contract on the CME represents 100 troy ounces of gold.
3. Strike price: The predetermined price at which the underlying asset will be bought or sold when the contract expires.
4. Expiration date: The date on which the contract expires, and the underlying asset is to be delivered or settled in cash.
5. Margin requirements: Futures contracts are typically traded on margin, meaning that traders are only required to deposit a percentage of the contract's value (called the "initial margin") to enter a position. Margin requirements are set by the exchange and can be adjusted depending on market conditions.

Futures contracts can be settled in one of two ways:

1. Physical delivery: The seller of the contract delivers the underlying asset to the buyer at the expiration date, and the buyer pays the agreed-upon price. Physical delivery is more common in commodity futures contracts.
2. Cash settlement: Instead of delivering the underlying asset, the contract is settled by a cash payment based on the difference between the futures price and the spot price of the asset at the expiration date. Cash settlement is more common in financial futures contracts, such as stock index futures or currency futures.

Pros and cons of futures contracts:

Pros:

1. Risk management: Futures contracts allow market participants to hedge against price fluctuations in the underlying assets.
2. Leverage: Trading on margin allows traders to control a large position with a relatively small investment.
3. Liquidity: Futures markets are typically highly liquid, making it easy for traders to enter and exit positions.

Cons:

1. Leverage risk: The use of leverage can magnify both profits and losses, potentially leading to significant losses if the market moves against a trader's position.
2. Margin calls: If the market moves against a trader's position, they may be required to deposit additional funds (a "margin call") to maintain their position.
3. Complexity: Futures contracts can be complex and may be difficult for some investors to understand, particularly those who are new to trading and investing.

1. Rollover costs: Because futures contracts have expiration dates, traders who wish to maintain their positions beyond the expiration must "rollover" their contracts to a later expiration date, which can involve additional costs and potential price discrepancies between the expiring contract and the new contract.

Examples to illustrate key concepts:

1. Hedging: An airline company expects to purchase a large quantity of jet fuel in six months. To protect itself against the risk of rising fuel prices, the airline buys jet fuel futures contracts. If the price of jet fuel rises, the profit from the futures contracts will offset the increased cost of purchasing the fuel, effectively hedging the risk.
2. Speculation: A trader believes that the price of gold will increase in the next three months. The trader buys a gold futures contract with an expiration date three months in the future. If the price of gold rises as expected, the trader can sell the contract before the expiration date, profiting from the difference between the purchase price and the higher selling price.

In summary, futures contracts are standardized agreements to buy or sell an underlying asset at a predetermined price and a specified future date. They serve various purposes, including hedging, speculation, and price discovery. While futures contracts can provide opportunities for risk management and profit, they also involve risks due to leverage, margin calls, and complexity. Traders and investors should carefully consider these risks before engaging in futures trading.

See Also

• IT Strategy (Information Technology Strategy)
• IT Governance
• Enterprise Architecture
• Chief Information Officer (CIO)
• IT Sourcing (Information Technology Sourcing)
• IT Operations (Information Technology Operations)
• E-Strategy