Futures in banking are standardized derivative contracts that obligate the buyer to purchase an underlying asset at a specified price and time in the future, while the seller is obligated to sell the asset at the agreed price and time. The underlying assets can be commodities, stocks, bonds, currencies, or indices.
Futures contracts are traded on exchanges, and they have standard sizes, maturities, and settlement procedures. They are used for hedging, speculation, and arbitrage.
Hedging: Futures contracts can be used to hedge against price fluctuations of the underlying asset. For example, a farmer can sell futures contracts to lock in a price for his crops, protecting against price declines. Similarly, a company can use futures to hedge against currency fluctuations by locking in an exchange rate for future transactions.
Speculation: Futures contracts can be used for speculation. Traders can take positions based on their views on the direction of the market, and profit from the price movements. Speculators add liquidity to the market and help to ensure that prices reflect the supply and demand for the underlying assets.
Arbitrage: Futures contracts can be used for arbitrage, which involves taking advantage of price discrepancies between markets. For example, if the price of a futures contract is higher than the spot price of the underlying asset, a trader can buy the asset in the spot market and sell it in the futures market, making a profit from the difference in prices.
Futures are marked to market daily, which means that the profits and losses from the contracts are settled daily. This reduces the risk of default and helps to ensure that the contract is honored at the expiration date. Futures can be settled in cash or through physical delivery of the underlying asset.
Futures trading involves high leverage and can be risky, as the losses can exceed the initial investment. Therefore, it is important to have a sound understanding of the market and the risks involved before trading futures.