Futures Contract
A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange.The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires. The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.
Futures Contract
Definition
A futures contract is a legal agreement to buy or sell a specific commodity, asset, or security at a predetermined price at a specified time in the future. The quality and quantity of the futures contract are standardized to facilitate trading on futures exchanges. The buyer of a futures contract is obligated to purchase and receive the underlying asset at the contract's expiration, while the seller is obligated to provide and deliver the underlying asset on the expiration date.
Origin
The origin of futures contracts can be traced back to 19th century America, where farmers and merchants began trading standardized commodity contracts on the Chicago Board of Trade (CBOT) to hedge against price volatility. Over time, the application of futures contracts expanded to financial assets such as stock indices, interest rates, and foreign exchange.
Categories and Characteristics
Futures contracts can be divided into two main categories: commodity futures and financial futures. Commodity futures include agricultural products, metals, and energy, while financial futures cover stock indices, interest rates, and foreign exchange. Commodity futures are characterized by their linkage to physical goods and are typically used for hedging price risks; financial futures are more often used for speculation and arbitrage.
Comparison with Similar Concepts
Futures contracts are similar to forward contracts but have key differences. Futures contracts are traded on exchanges, are highly standardized, and have high liquidity; forward contracts are usually over-the-counter, offering more flexibility but less liquidity.
Specific Cases
Case 1: Suppose a farmer expects the price of wheat to fall in the future. He can sell wheat futures contracts to lock in the current price, thus hedging against the risk of price decline. If the price of wheat indeed falls by the expiration date, the farmer can buy back the wheat at a lower market price, achieving the hedge.
Case 2: An investor expects the price of crude oil to rise in the next three months. He can buy crude oil futures contracts to profit from the anticipated price increase. If the price of crude oil rises as expected, the investor can sell the contracts at a higher price in the futures market, earning the price difference.
Common Questions
1. What is the leverage effect of futures contracts?
Futures contracts typically use margin trading, meaning investors only need to pay a portion of the contract's value to control a larger amount, thereby amplifying both gains and risks.
2. Do futures contracts require physical delivery upon expiration?
Not necessarily. Most futures contracts are closed out through offsetting trades before expiration to avoid physical delivery, with only a few contracts resulting in actual physical delivery.
