Financial Futures

Definition

Financial Futures are standardized contracts traded on an exchange that obligate the purchase or sale of a financial instrument (such as currencies, interest rates, or various financial assets) at a predetermined future date and price. These instruments allow investors to hedge against risk, speculate on future price movements, or gain exposure to various financial markets with relative price transparency.

Examples

Currency Futures: A contract to buy or sell a specific currency at a specified exchange rate on a future date. For example, a U.S. importer may buy Japanese Yen futures to fix the cost of upcoming purchases from Japan.
Interest Rate Futures: These contracts are based on the future value of interest rate instruments such as government bonds. For example, a company expecting to borrow funds in the future may use interest rate futures to lock in the current interest rate.
Stock Index Futures: Contracts based on the value of a stock market index like the S&P 500. An investor might use these to hedge against potential declines in the market by going short on an index future.

Frequently Asked Questions (FAQs)

Q1: What is the primary purpose of financial futures? A1: The primary purpose of financial futures is to hedge against risk, allow for speculation on the future price movements of the financial instruments, and to manage portfolios through diverse investment strategies.

Q2: How do financial futures differ from other futures contracts? A2: Financial futures specifically involve financial assets such as currencies, interest rates, or indices, whereas other futures contracts might involve commodities such as oil, gold, or agricultural products.

Q3: What is the role of the exchange in financial futures trading? A3: The exchange acts as an intermediary between buyers and sellers, providing a standardized place to trade these contracts, ensuring contract fulfillment, transparency, and reducing counterparty risk.

Q4: Can individuals participate in financial futures markets? A4: Yes, individuals can participate directly through brokers or indirectly through mutual funds or exchange-traded funds (ETFs) that use financial futures in their strategies.

Q5: What is the significance of the London International Financial Futures Exchange (LIFFE)? A5: LIFFE is one of the main exchanges where financial futures and options are traded. It offers a regulated trading environment for various financial derivatives including futures.

Hedge: A strategy used to offset or reduce the risk of adverse price movements in an asset, by taking an opposite position in a related security.
Portfolio Insurance: Techniques used to hedge a portfolio of investments against market risk to protect against significant losses.
Futures Contract: An agreement traded on an exchange to buy or sell a specific quantity of a commodity or financial instrument at a specified price at a future date.

Online References

Suggested Books for Further Studies

“Options, Futures, and Other Derivatives” by John Hull: A comprehensive guide to a variety of derivatives, including financial futures, offering both theoretical and practical insights.
“Futures and Options Markets: An Introduction” by Colin A. Carter: An introductory book for understanding how futures and options markets operate.
“Financial Derivatives: Pricing and Risk Management” by Jamil Baz and George Chacko: This book delves into the pricing and risk management techniques in the derivatives market.

Accounting Basics: “Financial Futures” Fundamentals Quiz

### What is a financial future? - [ ] A savings account with fixed returns. - [ ] A derivative contract based on physical commodities. - [x] A standardized contract traded on an exchange involving financial instruments. - [ ] An advanced form of financial savings plan. > **Explanation:** A financial future is a standardized contract traded on an exchange that involves financial instruments like currencies or interest rates. ### Can financial futures be used to hedge against currency risk? - [x] Yes, financial futures can hedge against currency risk. - [ ] No, they are only for commodities. - [ ] Yes, but only in specific markets. - [ ] No, they increase currency risk. > **Explanation:** Financial futures can be used to hedge against currency risk by locking in exchange rates for future transactions. ### What underlying assets can financial futures be based on? - [x] Currencies, interest rates, and financial indices. - [ ] Only commodities like gold and oil. - [ ] Real estate markets. - [ ] Only government bonds. > **Explanation:** Financial futures can be based on various financial assets including currencies, interest rates, and financial indices. ### Who typically uses financial futures? - [ ] Only central banks. - [x] Investors, corporations, and financial institutions. - [ ] Only retail bankers. - [ ] Real estate agents. > **Explanation:** Financial futures are used by a range of participants including investors, corporations, and financial institutions to hedge risks and speculate on future price movements. ### Which exchange is known for trading financial futures in the UK? - [ ] NASDAQ - [x] LIFFE - [ ] NYSE - [ ] Tokyo Stock Exchange > **Explanation:** LIFFE (London International Financial Futures and Options Exchange) is known for trading financial futures in the UK. ### What is the primary benefit of using financial futures? - [ ] Guaranteed profit. - [ ] Fixed long-term savings. - [x] Hedging against financial risks. - [ ] Immobilizing capital. > **Explanation:** The primary benefit of financial futures is to hedge against financial risks such as price fluctuations in expenses and revenues. ### What does standardized mean in the context of financial futures? - [ ] The contracts have variable terms. - [x] The contracts have fixed terms and conditions. - [ ] Only some contracts are standardized. - [ ] The price is fixed by the government. > **Explanation:** Standardized means that the contracts have fixed terms and conditions including quantity, date, and price which are set by the exchange. ### How is counterparty risk managed in financial futures trading? - [ ] Through personal agreements. - [ ] By ignoring it. - [x] Through the exchange's clearing house. - [ ] Using only cash transactions. > **Explanation:** Counterparty risk in financial futures trading is managed by the exchange's clearing house, which acts as an intermediary and ensures contract fulfillment. ### What can financial futures allow investors to do? - [ ] Completely avoid market risks. - [x] Speculate on future price movements. - [ ] Guarantee returns. - [ ] Deposit funds safely. > **Explanation:** Financial futures allow investors to speculate on future price movements, providing opportunities for gains or hedging against losses. ### What important aspect differentiates financial futures from options? - [ ] Financial futures involve fixed interest rates. - [ ] Financial futures are not traded on exchanges. - [ ] Financial futures are exclusively for commodities. - [x] Financial futures obligate the purchase or sale at contract maturity, whereas options give the right but not the obligation. > **Explanation:** Unlike options, financial futures obligate the contract parties to buy or sell the financial asset at contract maturity at the agreed-upon price.

Thank you for embarking on this journey through our comprehensive accounting lexicon on financial futures and tackling our sample exam quiz questions. Keep striving for excellence in your financial knowledge!