FUTURES AND FORWARDS

1. A clear explanation of key concepts.

2. Short notes summarizing important topics.
3. Examples to simplify learning.
4. MCQ questions for practice.

Understanding Futures and Forwards

1. Introduction to Derivatives

Derivatives are financial contracts whose value depends on an underlying asset (stocks,
commodities, currencies, etc.).

The most common types include Forwards, Futures, Options, and Swaps.

2. Forwards Contracts

A forward contract is a private agreement between two parties to buy/sell an asset at a future
date at a pre-agreed price.

They are customized and traded over-the-counter (OTC).

Example:

Suppose a farmer agrees to sell wheat to a food company at ₹30/kg after three months.
Regardless of the market price after three months, both parties must follow the contract.

3. Futures Contracts

A futures contract is similar to a forward contract but is standardized and traded on

exchanges.

Clearinghouses act as intermediaries, reducing counterparty risk.

Key Features:

Traded on exchanges (e.g., NSE, BSE).

Standardized contract size and settlement dates.

Marked-to-market daily, meaning profits and losses are settled daily.

Example:

An investor buys a futures contract for 100 shares of Company X at ₹500 per share. If the
price rises to ₹520, the investor makes a ₹2000 profit (100 × ₹20).

4. Differences between Forwards and Futures

5. Margin and Marking-to-Market

Initial Margin: A deposit required to enter a futures contract.

Maintenance Margin: The minimum balance required; if the account balance falls below this,
a margin call occurs.

Marking-to-Market: Adjusting the contract’s value daily based on market movements.

Example:

If a trader holds a futures contract and the price moves in their favor, their margin account is
credited. If it moves against them, funds are deducted.
 6. Hedging, Speculation, and Arbitrage

Hedging: Reducing risk by taking an opposite position in derivatives (e.g., farmers hedge
against falling crop prices).

Speculation: Traders take positions expecting to profit from price movements.

Arbitrage: Exploiting price differences in different markets for risk-free profit.

Short Notes on Important Topics

1. Futures vs. Forwards: Futures are standardized, exchange-traded, and involve daily
settlements, while forwards are private agreements with more flexibility.

2. Marking-to-Market: A daily process where futures gains/losses are settled.

3. Margin System: Traders must maintain an initial and maintenance margin to manage
risk.

4. Hedging: Investors use futures to minimize risk exposure in financial markets.

5. Arbitrage Opportunities: When the same asset has different prices in different
markets, traders can buy low and sell high for a profit.
MCQ Questions

1. What is the primary difference between a forward and a futures contract?

a) Forward contracts are exchange-traded, while futures are OTC

b) Futures contracts are standardized, while forwards are customizable

c) Forward contracts have daily settlement, while futures do not

d) There is no difference

Answer: b) Futures contracts are standardized, while forwards are customizable

2. In futures trading, marking-to-market means:

a) The contract is physically settled at expiry

b) The contract value is adjusted daily based on market prices

c) The contract is settled in cash at expiry

d) The exchange takes over the contract

Answer: b) The contract value is adjusted daily based on market prices

3. Who acts as an intermediary in futures contracts to reduce counterparty risk?

a) Brokers

b) Clearinghouse

c) Speculators

d) Arbitrageurs
Answer: b) Clearinghouse

4. What is the purpose of the maintenance margin?

a) To cover broker fees

b) To ensure sufficient funds are available for losses

c) To make trading risk-free

d) To increase leverage

Answer: b) To ensure sufficient funds are available for losses

5. If a farmer enters into a futures contract to sell wheat in three months at ₹30/kg, they are:

a) Hedging against price drops

b) Speculating on price increases

c) Engaging in arbitrage

d) Avoiding transaction fees

Answer: a) Hedging against price drops

1. How Do Futures and Forwards Work?
Forward Contract Example

Imagine you own a company that makes chocolates, and you need cocoa beans. You worry
that cocoa prices might increase in three months, so you enter a forward contract with a
farmer:

• You agree to buy 10,000 kg of cocoa at ₹200/kg in three months.

• If cocoa prices rise to ₹250/kg, you still pay ₹200/kg, saving ₹5,00,000.
• If prices drop to ₹180/kg, you must still pay ₹200/kg, losing ₹2,00,000.

Key Takeaways:

• It protects against price fluctuations.

• No daily settlement (settled on contract expiry).
• Higher default risk since it's a private agreement.

Futures Contract Example

A trader expects the stock of ABC Ltd. to rise from ₹500 to ₹550 in a month. They buy a
futures contract for 100 shares at ₹500.

• If the price rises to ₹520 tomorrow, the trader makes ₹2000 (100 × ₹20).
• If the price falls to ₹480, they lose ₹2000.
• Profits/losses are settled daily through marking-to-market.

Key Takeaways:

• Standardized contracts traded on exchanges.

• Daily profit/loss adjustments ensure lower default risk.
• Requires margin deposits to cover losses.

2. Why Use Futures and Forwards?

1. Hedging: Protecting against future price movements.

o Example: A fuel-dependent airline locks in fuel prices to avoid cost
spikes.
2. Speculation: Traders aim to profit from price changes.
o Example: A speculator buys Nifty futures expecting the index to rise.
3. Arbitrage: Profiting from price differences between markets.
o Example: Gold prices are ₹50,000 per 10g in Delhi but ₹49,500 in
Mumbai. A trader buys in Mumbai and sells in Delhi for risk-free profit.
3. Marking-to-Market and Margins Explained
Margin Concept

When trading futures, you don’t need to pay the full amount upfront, only a percentage
called initial margin (5-10% of contract value).

• Initial Margin: Required to enter a trade.

• Maintenance Margin: Minimum balance needed in the account.
• Margin Call: If losses reduce the balance below the maintenance margin, the
trader must add more funds.

Marking-to-Market Example

Suppose a trader buys a futures contract for 100 shares at ₹200/share.

• Day 1: Stock price rises to ₹210 → Profit: ₹1,000 (100 × ₹10) → Credited to
trader’s account.
• Day 2: Stock price drops to ₹190 → Loss: ₹2,000 → Deducted from trader’s
account.

The process continues daily until the contract expires or is closed.

4. How Are Futures Settled?

1. Cash Settlement: No physical delivery; profit/loss is settled in cash.

2. Physical Delivery: The actual asset is exchanged at contract expiry.

Example:
If an oil company buys crude oil futures, they might take physical delivery of barrels of oil.
A stock trader, however, will prefer cash settlement.

5. Key Differences Between Futures and Options

Example:

• Futures: Buying Nifty futures means you must buy/sell at expiry.

• Options: Buying a Nifty call option gives you the right (but not obligation) to buy
at a set price.
Additional MCQs for Practice

6. In a futures contract, daily settlement of profit/loss is called:

a) Hedging
b) Marking-to-market
c) Arbitrage
d) Margin call

Answer: b) Marking-to-market

7. If a trader fails to maintain the required margin in their account, they receive:
a) A dividend
b) A margin call
c) A risk-free return
d) A premium refund

Answer: b) A margin call

8. Which of the following is NOT a feature of forward contracts?

a) Customization
b) Traded on exchanges
c) High counterparty risk
d) Private agreement

Answer: b) Traded on exchanges

9. An arbitrageur profits by:

a) Taking opposite positions to reduce risk
b) Speculating on future price movements
c) Buying low in one market and selling high in another
d) Paying margins daily

Answer: c) Buying low in one market and selling high in another

10. If a futures contract is cash-settled, it means:

a) The asset is delivered physically
b) Profit/loss is adjusted in cash
c) There is no financial transaction
d) The trader pays the full contract value upfront

Answer: b) Profit/loss is adjusted in cash

Would you like me to simplify any specific topic further or add more examples?
Here are 25 Multiple Choice Questions (MCQs) covering Futures and Forwards
contracts:

Basic Concepts of Futures & Forwards

1. A forward contract is best described as:

a) A standardized agreement traded on an exchange

b) A private agreement between two parties to buy/sell an asset in the future

c) A financial instrument issued by the government

d) A contract that cannot be customized

Answer: b) A private agreement between two parties to buy/sell an asset in the future

2. Which of the following is a key difference between forward and futures contracts?

a) Forwards are standardized; futures are customized

b) Futures are standardized; forwards are customized

c) Both are customized agreements

d) Both are traded on exchanges

Answer: b) Futures are standardized; forwards are customized

3. Which of the following is true about futures contracts?

a) They are traded over-the-counter (OTC)

b) They have daily settlement through marking-to-market

c) They are non-transferable

d) They do not require margins

Answer: b) They have daily settlement through marking-to-market

Futures and Forwards Trading

4. What is the purpose of marking-to-market in futures trading?

a) To settle profits/losses on a daily basis

b) To prevent arbitrage

c) To eliminate counterparty risk completely

d) To ensure the contract is held until expiry

Answer: a) To settle profits/losses on a daily basis

5. The process of adjusting a trader’s account balance based on daily price changes in a
futures contract is called:

a) Hedging

b) Margin call

c) Marking-to-market

d) Arbitrage
Answer: c) Marking-to-market

6. Who acts as an intermediary in futures contracts to reduce counterparty risk?

a) Brokers

b) Clearinghouse

c) Speculators

d) Arbitrageurs

Answer: b) Clearinghouse

7. In futures trading, a margin call occurs when:

a) The trader fails to settle the contract at expiry

b) The maintenance margin falls below the required level

c) The trader profits from a price increase

d) The clearinghouse cancels the contract

Answer: b) The maintenance margin falls below the required level

8. Which of the following is NOT a feature of a futures contract?

a) Traded on exchanges

b) Customizable contract size and expiry date

c) Daily settlement of profit/loss

d) Standardized contract

Answer: b) Customizable contract size and expiry date

Margins and Risk Management

9. What is the purpose of the maintenance margin in a futures contract?

a) To cover the cost of trading commissions

b) To ensure sufficient funds are available for losses

c) To make trading risk-free

d) To pay dividends to traders

Answer: b) To ensure sufficient funds are available for losses

10. Which of the following statements about initial margin is true?

a) It is the full contract value that must be paid upfront

b) It is a percentage of the contract value that traders must deposit to enter a trade

c) It is only required in options trading, not futures

d) It is refunded once the contract expires

Answer: b) It is a percentage of the contract value that traders must deposit to enter a
trade
11. If the futures price moves against a trader’s position, the trader must:

a) Close the contract immediately

b) Add additional funds to meet the margin requirement

c) Receive a margin refund

d) Ignore the changes until expiry

Answer: b) Add additional funds to meet the margin requirement

Hedging, Speculation, and Arbitrage

12. A farmer who wants to protect against the risk of falling crop prices would use
futures for:

a) Arbitrage

b) Speculation

c) Hedging

d) Diversification. (Answer: c) Hedging)

13. Speculators in the futures market aim to:

a) Reduce risk by taking an opposite position

b) Profit from price movements without holding the underlying asset

c) Match buyers and sellers in the market

d) Ensure price stability in the market

Answer: b) Profit from price movements without holding the underlying asset

14. Arbitrage in futures markets occurs when a trader:

a) Takes a position without sufficient margin

b) Buys in one market and sells in another to profit from price differences

c) Holds the contract until expiry

d) Engages in high-frequency trading

Answer: b) Buys in one market and sells in another to profit from price differences

Settlement and Expiry

15. How is a futures contract settled?

a) Only through physical delivery of the asset

b) Only through cash payment

c) Either through physical delivery or cash settlement

d) By canceling the contract before expiry

Answer: c) Either through physical delivery or cash settlement

16. Which type of futures contract does not require delivery of the underlying asset?

a) Commodity futures

b) Stock index futures

c) Agricultural futures

d) Gold futures
Answer: b) Stock index futures

17. If a trader holds a futures contract until expiration and it is cash-settled, they will:

a) Receive the physical asset

b) Pay/receive the difference between the contract price and the settlement price

c) Be exempt from all margin requirements

d) Avoid all market fluctuations

Answer: b) Pay/receive the difference between the contract price and the settlement
price

Pricing and Market Behavior

18. The price of a futures contract is typically influenced by:

a) Past performance of the stock

b) Supply and demand, interest rates, and dividends

c) The number of traders in the market

d) Government restrictions only

Answer: b) Supply and demand, interest rates, and dividends

19. If the futures price is higher than the expected future spot price, the market is in:

a) Contango

b) Backwardation

c) Equilibrium

d) Arbitrage mode

Answer: a) Contango

20. If the futures price is lower than the expected future spot price, the market is in:

a) Contango

b) Backwardation

c) Hedging mode

d) Arbitrage mode

Answer: b) Backwardation

Options vs. Futures

21. Which of the following is NOT true about futures contracts?

a) They require daily margin settlement

b) They allow unlimited profit potential

c) They provide a right but not an obligation

d) They have high leverage

Answer: c) They provide a right but not an obligation

22. A key difference between options and futures is that options provide:

a) An obligation to buy/sell at expiry

b) A right but not an obligation to buy/sell

c) No leverage

d) No exposure to market risk

Answer: b) A right but not an obligation to buy/sell

Real-Life Applications

23. An airline company buying oil futures is an example of:

a) Speculation

b) Hedging

c) Arbitrage

d) Scalping

Answer: b) Hedging

24. A gold trader who locks in a purchase price using a forward contract is:

a) Eliminating all risks

b) Engaging in speculation

c) Hedging against price fluctuations

d) Trading without margin

Answer: c) Hedging against price fluctuations

25. Who benefits in a futures contract when prices increase?

a) The seller

b) The buyer

c) The clearinghouse

d) The government

Answer: b) The buyer