Introduction to Forwards and Futures

1Forward contracts and their limits

A forward is a private (bilateral, OTC) agreement to buy or sell an asset on a future date at terms fixed today: price, quantity, quality, place and settlement. Its purpose is to lock in the price and remove price risk. Nothing changes hands until the agreed date, and both sides must perform whatever the price then.

Example Gold spot is ₹62,130 per 10 g; you agree a one-month forward at ₹62,337. If gold is ₹62,700 in a month, you gain ₹363 (buy at 62,337, worth 62,700). If it is ₹62,100, you lose ₹237.

Weaknesses:

• Liquidity risk: tailor-made and unlisted, so hard to exit before maturity.
• Counterparty (default, credit) risk: a party may walk away when the price moves against it (the seller when prices rise, the buyer when they fall).
• Also poor transparency and messy bilateral settlement.

Remember

• Forward = OTC, customised, illiquid, counterparty risk.

Practise this concept (3 questions)

2Futures contracts

A futures contract is a standardised forward traded on an exchange, with settlement guaranteed by the clearing corporation. Buying is a long position, selling a short position; no money or asset changes hands at the start except margins.

Features: traded through the exchange on a central platform; price discovered by buyers and sellers; margins paid by both parties; quality and quantity standardised. The exchange fixes everything except the price.

Limitations: limited maturities and underlyings, little flexibility in design, and the administrative cost of daily mark-to-market.

Remember

• Both buyer and seller pay margin.

Practise this concept (3 questions)

3Contract specifications

The exchange sets the contract specifications. Using Nifty futures as the example:

• Underlying: the index or stock, and its cash market price (spot price).
• Contract size (lot size / multiplier): set by the exchange and revised as prices change. Contract value = futures price × lot size. SEBI requires a derivative contract value of at least ₹15 lakh at introduction, with lot sizes reviewed so the value stays between ₹15 lakh and ₹20 lakh (effective November 2024; earlier ₹5–10 lakh).
• Contract cycle: NSE index and stock futures follow a three-month cycle: near, next and far month. A new far-month contract starts the day after the near month expires.
• Expiry day: the last trading day; open positions are compulsorily settled. To continue, roll over (for a long: sell the expiring contract and buy the next, at the same time). SEBI now lets each exchange choose either Tuesday or Thursday for all its equity derivatives: NSE uses Tuesday, BSE uses Thursday. Monthly contracts expire on the last such day of the month (or the previous trading day if a holiday). Each exchange may offer only one weekly benchmark index options contract. Changing the expiry day needs SEBI approval.
• Tick size: minimum price move; ₹0.05 for Nifty futures.
• Daily settlement price: the weighted average price of the last half hour of that contract.
• Final settlement price: the closing price of the underlying in the cash market on expiry day.
• Trading hours: 9:15 a.m. to 3:30 p.m., Monday to Friday. Trading holidays close the exchange; on clearing holidays trading happens but there is no settlement (banks closed).

Sensex futures (BSE) have a contract size of 20, tick ₹0.05, weekly and monthly contracts expiring on Thursdays, and cash settlement. Because Sensex and Nifty move together, traders use them for pairs trading.

Example Nifty futures at 24,894.25 × lot 65 = contract value of about ₹16.18 lakh.

Remember

• Daily settlement: last 30 minutes' weighted average. Final: underlying's closing price.
• NSE expiry: Tuesday. BSE expiry: Thursday.

Practise this concept (12 questions)

4Key terms: basis, cost of carry, margins, open interest, price band, positions

• Basis = spot price − futures price. If futures are above spot, basis is negative. Basis differs for each expiry, the difference between expiries reflects the cost of carry between them, and basis becomes zero at expiry because final settlement uses the spot price.
• Cost of carry = financing (and for commodities storage and insurance) minus income from the asset. For equities: interest minus dividends.

Example Share at ₹100, borrowing at 6% for a year, expected dividend ₹2. Cost of carry = 6 − 2 = ₹4, so break-even futures price = ₹104.

• Initial margin: deposited when opening a position, by both buyer and seller, higher for more volatile assets.

Example Long 1 Nifty future at 22,250 × lot 25 = ₹5,56,250. At 10% initial margin, deposit ₹55,625. If it closes at 22,308.70, the mark-to-market gain is 58.70 × 25 = ₹1,468, credited that day; tomorrow's MTM starts from 22,308.70.

• Mark to market (MTM): profits and losses settled every day, collected from losers and paid to gainers.
• Open interest: contracts outstanding, counted one side only (total longs = total shorts). It shows market depth. Volume is the number of contracts traded in a period.

Example Day 1: A shorts 50 to B → OI 50. Day 2: C buys 100 from D → OI 150. Day 3: A buys back 50 from new seller E → OI stays 150. Day 4: C sells 100 and D buys 100 to close → OI falls to 50.

• Price band: the daily range around the previous close (or, on day one, the underlying's close) within which the contract can trade.
• Long / short / open position: outstanding buy / sell / either. Naked position: futures with no position in the underlying. Calendar spread: long one expiry and short another on the same underlying; it becomes an ordinary open position when the near leg expires or one leg is closed. Opening a position increases it; closing reduces it.

Remember

• Basis = spot − futures; zero at expiry.
• Open interest counts one side only.

Practise this concept (11 questions)

5Forwards versus futures

Remember

• Futures remove counterparty risk through the clearing corporation.

Practise this concept (3 questions)

6Payoffs of futures

A payoff chart shows profit or loss at expiry (y-axis) against the underlying price at expiry (x-axis). Futures payoffs are linear, and both long and short positions have unlimited profit or loss potential (subject to price not going below zero).

• Long futures at 100: at 150 → +50; at 70 → −30.
• Short futures at 100: exactly the opposite; at 60 → +40; at 150 → −50.

Example Sold one stock future at ₹278 (lot 1,200) and bought it back at ₹265. Profit = (278 − 265) × 1,200 = ₹15,600.

Remember

• Long gains when price rises; short gains when it falls.

Practise this concept (5 questions)

7Pricing futures

Cost of carry (no-arbitrage) model: owning the asset today and carrying it to the future date must cost the same as buying futures, otherwise arbitrage closes the gap.

Formula Fair futures price = Spot price + Cost of carry − Inflows (dividends, interest); F = S × (1 + r − q)^T, or with continuous compounding F = S × e^((r − q)T)

Example Index at 17,500, financing 12%, index yield 4%, 90 days. F = 17,500 × (1.08)^(90/365) = 17,835.26 (17,848.63 using the exponential form).

• If futures trade above fair value: cash and carry arbitrage (buy spot, sell futures).
• If futures trade below fair value: reverse cash and carry (sell spot, buy futures).

Example Gold spot ₹62,130, carrying cost ₹100 for three months, fair value ₹62,230. Futures at ₹62,280 → buy gold, sell futures, risk-free profit ₹50 (before costs).

Transaction costs, taxes and margins create no-arbitrage bounds around fair value; inside them arbitrage does not pay. Lower costs mean narrower bounds and more efficient markets. The model assumes the asset is abundant, not seasonal, storable and can be sold short, with no costs, taxes or margins, so it suits forwards better than futures and fails for seasonal or non-storable assets.

Convenience yield is the intangible benefit of physically holding a scarce commodity (for example during a flood or crop failure). It can outweigh carrying costs and push futures below spot; it arises in commodities, not financial assets.

Expectations model: the futures price is the market's expected future spot price. Contango: futures above spot (rising prices expected). Backwardation: futures below spot (falling prices expected).

Remember

• Futures > fair value → cash and carry. Futures < fair value → reverse cash and carry.
• Contango: futures > spot. Backwardation: futures < spot.

Practise this concept (8 questions)

8Price discovery and convergence

Every participant is trying to predict the spot price at one moment: the close on expiry day. That makes futures a tool for price discovery of the future spot price. At expiry, futures and spot prices converge, which is why all futures settle at the underlying's closing price.

Remember

• Futures price = expected spot at expiry; they converge on the last day.

Practise this concept (1 question)

9Uses of futures: hedgers, traders and arbitrageurs

• Hedgers reduce risk (a farmer selling wheat futures; an investor selling index futures to protect a portfolio).
• Traders (speculators) take naked or spread positions to profit from their views; futures need less money than the underlying, but leverage cuts both ways. Traders provide the depth that lets hedgers hedge.
• Arbitrageurs lock in risk-free profits from mispricing and link markets.

Example Spot ₹100, futures ₹110, lot 50. Buy spot and sell futures, locking in ₹10 per share. At expiry, whether the price is ₹108 (+8 on cash, +2 on futures) or ₹95 (−5 on cash, +15 on futures), the profit is ₹500 for the lot, before costs.

Arbitrage still has risks: delays between legs, an illiquid leg that does not fill, or physical settlement requiring extra trades.

Systematic and unsystematic risk: total risk = unsystematic (company or industry specific, such as a strike or losing a key manager, which diversification reduces) + systematic (market-wide, such as policy changes, currency moves or war, which cannot be diversified away). Stock futures hedge a single stock's total risk; index futures hedge a portfolio's systematic risk.

Beta measures a stock's sensitivity to the index: beta 2 means it moved 20% when the index moved 10%. Beta above 1 = aggressive; below 1 = conservative. Portfolio beta is the weighted average of stock betas.

Example Betas 0.5, 1.1, 1.3 and 0.9 with weights 35%, 15%, 20% and 30%: portfolio beta = 0.175 + 0.165 + 0.26 + 0.27 = 0.87.

Formula Number of index futures contracts to hedge = (Portfolio value × Portfolio beta) ÷ Value of one index futures contract

A single stock can be hedged 1:1 with its own futures; a portfolio cannot, because it differs from the index.

Hedging terms:

• Long hedge: buy futures now to protect against prices rising before you invest money you will receive later.
• Short hedge: sell futures to protect a holding you plan to sell.
• Cross hedge: use a closely related asset's futures when none exist for yours (crude oil futures for jet fuel). Hedging a portfolio with index futures is a form of cross hedge.
• Hedge contract month: choose the contract expiring just after the date you will unwind (to sell on 20 June, short June futures, not May).

Spreads: a calendar (time, horizontal) spread is long and short the same underlying in different months; an inter-commodity spread uses different products with the same expiry. Only calendar spreads trade in equity derivatives. Spreads are hedged positions, so they attract lower margins than two separate legs. Calendar spreads are counted against the near month; extra far-month contracts count as naked.

Types of arbitrage: cash and carry; reverse cash and carry; inter-exchange (the same contract priced differently on NSE and BSE, buy on the cheaper and sell on the dearer).

Formula F = S + C, or F = S(1 + r)^T, or F = S × e^(rT)

Remember

• Beta > 1 aggressive; < 1 conservative.
• Hedge contracts = (Vp × βp) ÷ Vi.
• Calendar spreads attract lower margin than two naked legs.

Practise this concept (11 questions)