Overview
A futures contract is a financial derivative obligating the buyer to purchase an asset, or the seller to sell an asset, at a predetermined future date and price. These contracts entail a commitment that differentiates them from options, which only confer the right—but not the obligation—to buy or sell an asset. Futures contracts can generate substantial profits or incur unlimited losses, depending on price movements.
Examples
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Commodity Futures: A trader agrees to buy 100 barrels of crude oil at $50 each, with delivery and payment due three months later. If oil prices rise to $60 per barrel, the trader profits. If prices fall, they incur a loss.
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Currency Futures: A multinational company hedges against foreign exchange risk by entering into a futures contract to buy 1 million euros at a fixed exchange rate in six months. This ensures budget certainty, regardless of future currency fluctuations.
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Financial Index Futures: An investor anticipates an uptrend in the stock market and buys an S&P 500 futures contract. If the index value increases, the investor profits. Conversely, a decrease results in a loss.
Frequently Asked Questions
What is the main difference between futures and options?
Futures are obligatory contracts to buy or sell at a specified future date and price, whereas options provide the right, but not the obligation, to transact at a specified price before the expiration date.
How can futures contracts be used for hedging?
Entities like farmers or multinational corporations use futures to lock in prices or exchange rates, thus protecting against adverse price movements and financial uncertainty.
What are the risks associated with futures contracts?
Given their leverage, futures involve high risk and potential for unlimited losses. Market volatility can significantly impact the value of contracts.
How does clearing work in futures markets?
A clearing house acts as an intermediary, ensuring that both parties fulfill their contractual obligations. This mitigates counterparty risk and ensures seamless execution.
Who are the primary players in the futures markets?
The futures market includes hedgers, who seek to mitigate risk, and speculators, who aim to profit from price movements. Brokers facilitate trades.
Derivatives
Financial contracts whose value is derived from an underlying asset, such as commodities, currencies, or securities.
Hedging
A risk management strategy used to offset potential losses in investments by taking an opposite position in a related asset.
Clearing House
An intermediary entity that facilitates the settlement of transactions, ensuring that both parties adhere to their contractual obligations.
Financial Futures
Contracts for financial instruments or indices rather than physical commodities. These might include stock index futures or interest rate futures.
Forward Contract
A customized contract to buy or sell an asset at a specified future date at a price agreed upon today. Unlike futures, forward contracts are not standardized or traded on exchanges.
Online Resources
Suggested Books for Further Studies
- “Options, Futures, and Other Derivatives” by John C. Hull
- “Futures, Options, and Swaps” by Robert W. Kolb and James A. Overdahl
- “Trading Commodities and Financial Futures: A Step-by-Step Guide to Mastering the Markets” by George Kleinman
Accounting Basics: “Futures Contract” Fundamentals Quiz
### What is the fundamental difference between a futures contract and an options contract?
- [x] A futures contract obligates the transaction.
- [ ] An options contract obligates the transaction.
- [ ] Both are identical financial instruments.
- [ ] Futures contracts are risk-free.
> **Explanation:** A futures contract obligates the parties to execute the transaction at the specified price and date, whereas an options contract provides the right, but not the obligation, to transact.
### In what way can futures contracts benefit hedgers?
- [x] By locking in prices and mitigating risk.
- [ ] By ensuring immediate delivery of goods.
- [ ] By avoiding all kinds of market risks.
- [ ] By offering unlimited profit potential without risk.
> **Explanation:** Hedgers use futures to lock in prices and protect against unfavorable price movements, thus providing financial certainty.
### Which of the following commodities might be covered under commodity futures?
- [x] Crude oil
- [ ] Real estate properties
- [ ] Intellectual properties
- [ ] Digital currencies only
> **Explanation:** Futures can cover a wide range of commodities including crude oil, which are standardized for trading on futures exchanges.
### Where are futures contracts typically traded?
- [x] On regulated exchanges
- [ ] In personal transactions only
- [ ] Over-the-counter markets exclusively
- [ ] Within private customer agreements only
> **Explanation:** Futures contracts are traded on regulated exchanges which provide standardization, transparency, and liquidity.
### What role does a clearing house play in futures markets?
- [x] It guarantees the contract by managing settlement and counterparty risk.
- [ ] It trades futures on behalf of all investors.
- [ ] It sells and buys assets directly from consumers.
- [ ] It interferes in the market prices setting.
> **Explanation:** A clearing house acts as an intermediary, guaranteeing contract fulfillment and managing counterparty risk.
### Why do traders engage in speculation using futures contracts?
- [x] To potentially make large profits from market movements.
- [ ] To minimize all market exposure and risk.
- [ ] To secure a physical asset immediately.
- [ ] To only ensure fixed currency conversion.
> **Explanation:** Traders engage in speculation to potentially profit from future price changes in the underlying asset.
### Which of the following best describes financial futures?
- [x] Futures contracts involving financial instruments or indexes.
- [ ] Contracts for immediate physical delivery of goods.
- [ ] Leases for property and assets.
- [ ] Non-standardized over-the-counter agreements.
> **Explanation:** Financial futures include contracts for financial instruments like stock indices or interest rates, adjusted for standardized trading on exchanges.
### What distinguishes futures contracts from forward contracts?
- [x] Futures are standardized and traded on exchanges, while forwards are not.
- [ ] Forward contracts are only traded on exchanges globally.
- [ ] Futures manage no interests in tangible assets.
- [ ] Forward contracts require no settlement.
> **Explanation:** Futures contracts are standardized and exchange-traded, while forward contracts are customized and traded over-the-counter.
### How is risk typically managed in the futures markets?
- [x] By using strategies such as hedging.
- [ ] By ignoring market volatility.
- [ ] By relying on immediate asset appreciation.
- [ ] By preventing any price agreement details.
> **Explanation:** Risk in futures markets is typically managed through strategies like hedging, which aim to mitigate the potential for adverse price movements.
### Who can trade in various futures markets?
- [x] Both brokers and dealers, depending on the market.
- [ ] Only investors without commissions.
- [ ] Solely government entities.
- [ ] Exclusive to individual consumers directly.
> **Explanation:** Depending on the specific futures market, both brokers and dealers may be permitted to trade, facilitating diverse market participation.
Thank you for embarking on this journey through our comprehensive accounting lexicon and tackling our challenging sample exam quiz questions. Keep striving for excellence in your financial knowledge!
