Part 3: Introduction to Forwards and Futures – Concepts, Terminology & Pricing

NISM Series VIII – Part 3: Introduction to Forwards and Futures – Concepts, Terminology & Pricing

This is Part 3 of our NISM Series VIII Equity Derivatives short notes. In this post, we cover forwards, futures contracts, all key terminologies used in the futures market, and the two main models for pricing futures. This topic typically carries high weightage in the NISM Series 8 exam.

Quick Answer (Featured Snippet): A futures contract is a standardised, exchange-traded agreement to buy or sell a fixed quantity of an asset at a predetermined price on a future date. Unlike forwards, futures are regulated, standardised, and backed by the exchange clearing corporation.

What is a Forward Contract?

A forward contract is a private, bilateral agreement between two parties to buy or sell an asset on a specific future date at a price agreed upon today. Key features:

• It is an OTC (Over-the-Counter) contract — not traded on any exchange
• Terms such as price, quantity, quality, delivery date, and place are customised between the two parties
• Both parties are legally obligated to complete the transaction on the agreed date
• Forwards are widely used in commodities, foreign exchange, equity, and interest rate markets

Limitations of Forward Contracts

Liquidity Risk: Since forwards are not listed on exchanges, other market participants cannot easily access or trade them. The tailor-made, private nature of these contracts creates illiquidity.

Counterparty Risk (Default Risk / Credit Risk): Either party may choose to default on the contract if market conditions move in their favour. There is no exchange or clearing house to guarantee settlement.

What is a Futures Contract?

Futures markets were created specifically to overcome the limitations of forward contracts. A futures contract is:

• An agreement executed through a regulated stock exchange
• To buy or sell a fixed amount of a commodity or financial asset
• On a future date at an agreed price
• Standardised in terms of contract size, expiry, and lot size

Simply put: Futures = Standardised forward contracts traded on an exchange

Key Features of a Futures Market

• Trading happens on a centralised exchange platform
• Price discovery takes place through the free interaction of buyers and sellers
• Both buyers and sellers are required to pay margins
• Contract quality and quantity are standardised and fixed in advance

Differences Between Forwards and Futures

Key Terminologies in the Futures Market

These definitions are directly tested in the NISM Series VIII equity derivatives exam.

Price-Related Terms

• Spot Price: The current market price of an asset in the cash (spot) market
• Futures Price: The price agreed upon today for a transaction that will occur at a future date
• Basis: The difference between spot price and futures price. If futures price > spot price → basis is negative. If spot price > futures price → basis is positive
• Cost of Carry: The total cost of holding an asset from today until the futures delivery date. For equity derivatives, cost of carry = Interest paid to finance the purchase – Dividends earned during the holding period

Contract-Related Terms

• Contract Cycle: The time period over which a futures contract is available for trading
• Expiration Day: The last trading day of a futures contract, after which it ceases to exist
• Tick Size: The minimum price movement allowed in a contract's quoted price (set by the exchange)
• Contract Size / Lot Size: The fixed number of units of the underlying in one futures contract. Contract Value = Price × Lot Size
• Price Band: The price range within which a contract is permitted to trade during a single session

Margin-Related Terms

• Margin Account: An account where the exchange requires traders to deposit funds as collateral to cover potential losses
• Initial Margin: The amount required to be deposited at the time of entering a futures contract
• Mark to Market (MTM) Settlement: Daily settlement of profits and losses based on the closing price. Profits are credited and losses are debited every trading day

Position-Related Terms

• Open Interest: The total number of outstanding (unsettled) contracts for a given underlying asset at any point in time
• Long Position: A net buy position — expecting prices to rise
• Short Position: A net sell position — expecting prices to fall
• Open Position: Any active long or short position that has not yet been squared off or settled
• Naked Position: A long or short futures position held without any corresponding position in the underlying asset
• Calendar Spread: Holding a long position in one expiry month and a short position in a different expiry month of the same underlying
• Opening a Position: Buying or selling a contract that increases your open interest
• Closing a Position: Buying or selling a contract that reduces or eliminates your open interest

Pay-off in Futures Contracts

The pay-off on a futures position is the profit or loss at the expiry of the contract based on the price of the underlying.

• Both long (buy) and short (sell) positions in futures carry unlimited profit potential and unlimited loss potential
• This makes the pay-off profile of futures contracts linear — profit and loss move proportionally with the underlying price

Futures Pricing Models

There is no single universal model for pricing futures because different assets have different supply-demand patterns, holding costs, and cash flow characteristics.

1. Cash and Carry Model (Non-Arbitrage Model)

This is the most commonly used approach for pricing equity index futures. It assumes that in an efficient market, arbitrage opportunities cannot persist.

The fair price of a futures contract is:

Futures Fair Price = Spot Price + Cost of Carry (until delivery)

Cost of carry includes:

• For financial assets: Interest cost – Dividend income
• For commodities: Interest cost + Storage cost + Insurance – Income from the asset

Assumptions of the Cash and Carry Model:

• Underlying asset is abundantly available in the cash market
• Demand and supply of the underlying is not seasonal
• The asset can be easily held and maintained
• Short selling of the underlying is permitted
• No transaction costs, no taxes, no margin requirements

Convenience Yield

For some commodities, the benefit of physically holding the asset (ready availability) has value — this is called convenience yield. When convenience yield is very high, it can make futures trade at a discount to the spot price. In such cases, reverse arbitrage is also not possible because lenders won't provide assets to sell short.

2. Expectancy Model

This model focuses on the expected future spot price rather than the current spot-futures relationship. It is relevant especially when:

• The underlying cannot be sold short
• The asset cannot be stored (e.g., weather derivatives, certain commodities)

Under this model:

• Futures can trade at a premium or discount to the current spot price
• The futures price signals the market's expectation of where the spot price will be at expiry

Price Discovery and Convergence at Expiry

On the expiry day, futures prices and spot prices must converge. There can be no difference between the two at the point of settlement. This is why all futures contracts settle at the underlying cash market price on expiry.

Example: If May Nifty futures are trading at 22,000 in March, the market is signalling that it expects the Nifty spot index to be around 22,000 at the end of May.

Hedging with Futures – Key Concepts

• Long Hedge: When you have a short position in the cash market and go long (buy) in the futures market to hedge the risk
• Short Hedge: When you have a long position in the cash market and go short (sell) in the futures market to hedge
• Cross Hedge: When you use index futures to hedge the risk of an individual stock portfolio — you are using an instrument that is not the exact same asset as your exposure

Systematic vs Unsystematic Risk

• Unsystematic risk (specific risk): Risk unique to a particular company or industry. Can be reduced through diversification
• Systematic risk (market risk): Risk that affects the entire market. Cannot be diversified away. This is managed using index futures

Quick Revision – Must-Know Points

• Futures = Standardised exchange-traded forwards
• Basis = Spot price – Futures price
• MTM settlement happens daily in futures markets
• Initial margin is based on 99% Value at Risk (VaR)
• Both long and short futures positions have unlimited profit and loss potential
• Cash and carry model assumes no arbitrage opportunities in an efficient market
• Futures and spot prices converge on the expiry date

Internal Links

• Part 2 – Understanding Index & Stock Market Indices
• Part 4 – Introduction to Options
• Take NISM Series 8 Mock Test
• NISM Series 8 Equity Derivatives Study Material

This is Part 3 of the NISM Series VIII Short Notes series on PassNISM.in. Continue to Part 4 – Introduction to Options, Greeks & Pay-off Charts.