Economics Derivatives Questions
The key characteristics of futures contracts are as follows:
1. Standardization: Futures contracts are standardized agreements that specify the quantity, quality, and delivery date of the underlying asset. This standardization ensures that all parties involved have a clear understanding of the terms and conditions.
2. Exchange-traded: Futures contracts are traded on organized exchanges, such as the Chicago Mercantile Exchange (CME) or the New York Mercantile Exchange (NYMEX). This provides a centralized marketplace where buyers and sellers can easily transact.
3. Margin requirements: Futures contracts require participants to deposit an initial margin, which is a small percentage of the contract value. This margin acts as a performance bond and ensures that both parties fulfill their obligations. Additionally, daily mark-to-market margin adjustments may be required to account for changes in the contract's value.
4. Leverage: Futures contracts allow investors to control a larger position in the underlying asset with a relatively small upfront investment. This leverage amplifies both potential gains and losses.
5. Clearinghouse involvement: A clearinghouse acts as an intermediary between the buyer and seller, guaranteeing the performance of the contract. It ensures that both parties fulfill their obligations and manages the settlement process.
6. Delivery or cash settlement: Futures contracts can be settled through physical delivery of the underlying asset or cash settlement. Most contracts are cash-settled, where the difference between the contract price and the market price at expiration is settled in cash.
7. Liquidity: Futures markets are highly liquid, with a large number of participants actively trading contracts. This liquidity allows for easy entry and exit from positions, reducing transaction costs and facilitating efficient price discovery.
8. Risk management: Futures contracts are widely used for risk management purposes. They allow market participants to hedge against price fluctuations in the underlying asset, reducing exposure to price volatility.
9. Short selling: Futures contracts enable investors to take short positions, allowing them to profit from a decline in the price of the underlying asset. This ability to sell short provides opportunities for speculation and hedging strategies.
10. Expiration dates: Futures contracts have specific expiration dates, after which they cease to exist. Traders can choose to close out their positions before expiration or let the contract settle according to its terms.