Forwards & Futures
Session 2 – Derivatives & Risk Management
Prof. Aparna Bhat
What this session will cover
⚫ Understanding the forward contract
⚫ Introducing the futures contract
⚫ Specifications of a futures contract
⚫ Payoffs from futures contracts
⚫ Final settlement vs. Closing out of futures contracts
⚫ Margins, daily MTM and leverage in futures contracts
2
Consider an example…
A farmer planting wheat during
October wants to lock in a
selling price for the wheat to be
harvested in March….
What are the risks
faced by the
farmer?
3
An arrangement to guard against the
price risk…
Delivery of wheat on
22nd March
This is known as
Wheat Bakery a ‘forward
farmer
Payment of funds contract’
on 22nd March
This is the oldest
derivative
contract!
4
Forward Contracts
⚫ A forward contract is an agreement to buy or sell a specified asset at a
certain time in the future for a specified price agreed upon at the time of
entering into the contract
⚫ Features
⚫ Requires the existence of two parties with matching needs
⚫ It is an OTC contract
⚫ Both parties have a mutual obligation to perform
⚫ There is risk of counterparty default
⚫ Forward contracts are non-transferable; mutual consent is required for
cancellation
⚫ No upfront payment is required for entering the contract
⚫ Forward contract is normally settled by delivery of the underlying asset
5
Spot Contracts v/s Forward Contracts
Spot contracts Forward contracts
⚫ Spot buyer must make ⚫ Forward buyer needs to
immediate payment pay only on contract
⚫ Spot seller must make maturity
immediate delivery of ⚫ Forward seller needs to
underlying asset deliver underlying asset
⚫ Spot contracts possible only on contract maturity
between unknown ⚫ Forward contracts possible
counterparties only between
counterparties known to
each other
6
How do forward contracts work?
⚫ Forward positions are opened by going “long” or “short”
⚫ The party who buys the contract is considered as assuming a
long position in the market with the expectation that price
will go up
⚫ The party who sells the contract is considered as assuming a
short position in the market with the expectation that price
will go down
⚫ If the price of the asset rises, the forward buyer makes a
profit
⚫ If the price is lower than the agreed price, the forward
7 seller
makes a profit.
7
Forward Contract: Example
A farmer wishes to sell 500kg of wheat after 3 months. Spot price is
Rs.22 per kg. The farmer expects the price to be steady at this level
even after 3 months when the crop will be ready but fears that the end
of Russia-Ukraine war might led to softening of wheat prices. To
safeguard itself he enters into forward contract for Rs 22/kg.
Meaning-
Contract means that he is obliged to deliver 500 kg of wheat after 3
months in exchange of getting Rs 11,000 (500*22)
Situation 1: Price falls to Rs 16/kg after 3 months, amount farmer gets
Rs. 11000 while amount he had got if no forward contract is Rs 8000
(500*16)
Situation 2: Price increases to Rs 30/kg after 3 months, amount
farmer still gets Rs 11,000 while amount he had got if no forward
contract is Rs 15000 (500*30)
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Payoff from forward contract
Suppose ST is spot price of underlying asset on
contract expiry date and K is the delivery price
Long forward: Agreement to buy the underlying
asset at a delivery price of K at time T.
⚫ Pay-off at expiry = ST – K (buy at K & sell at ST)
Short forward: Agreement to sell the underlying asset
at a delivery price of K at time T.
⚫ Pay-off at expiry = K – ST (buy at ST & sell at K)
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Payoff for long & short forward
positions
10
Risks in a forward contract
⚫ Counterparty risk
⚫ Farmer cannot deliver the promised quantity
⚫ Bakery does not pay the agreed upon price
⚫ Liquidity risk
⚫ Customized contracts and not listed on an exchange
⚫ Hence entry and exit difficult
⚫ Lack of transparency in price and volumes
⚫ Difficulties in contract settlement
11
Futures contracts
⚫ Forwards involve credit risk hence unsuitable for small investors
⚫ Non-negotiability of forwards leads to lack of widespread
investor participation, low liquidity and poor price discovery
⚫ Trading on a centralized platform like a futures exchange
mitigates the credit risk
⚫ Centralized trading and clearing requires standardization of
contracts
⚫ Futures contract is a forward contract
⚫ with standardized terms
⚫ traded on an organized exchange
⚫ follows a daily settlement procedure
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Forwards and futures - distinction
Forwards Futures
⚫ Traded Over the counter ⚫ Exchange traded
⚫ Custom-made contracts ⚫ Standardized contracts
⚫ Counterparties bear credit ⚫ The CCP bears credit risk
risk ⚫ Initial margin and daily
⚫ No margins MTM margins
⚫ Non-negotiable and settled ⚫ Negotiable; Delivery is rare
by delivery; close-out and close-out easy
difficult ⚫ Published price-volume
⚫ No published price-volume data
information
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Specifications of a futures contract
⚫ Contract Size
⚫ Quotation unit
⚫ Minimum price fluctuation (tick size)
⚫ Contract grade
⚫ Trading hours
⚫ Settlement Price
⚫ Delivery terms
⚫ Daily price limits and trading halts
14
Specifications of index futures
contracts traded on NSE
Nifty NiftyBank NiftyFinancial Nifty Midcap Nifty Next 50 Stock futures
Services select
Contract size 25 15 40 75 10 Stock-specific
Contract cycle 3-month trading cycle - near month, mid-month and far-month
Expiry day Last Thursday of Last Wednesday Last Tuesday of Last Monday of Last Friday of Last Thursday of
expiry month of expiry month expiry month expiry month expiry month expiry month
Tick size Rs.0.05 Rs.0.05 Rs.0.05 Rs.0.05 Rs.0.05 Rs.0.05
Daily settlement price Last half-hour's weighted average price for that futures contract
Final settlement price Closing price of underlying index or stock in cash market on last trading day
Trading hours 9:15 am to 3:30 pm
Delivery terms Cash settlement Physical settlement
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Specifications of currency futures
contracts traded on NSE
Symbol USDINR EURINR GBPINR JPYINR
Market Type N N N N
1 - 1 unit
1 - 1 unit 1 - 1 unit denotes
1 - 1 unit denotes 1000 denotes 1000
Unit of trading denotes 1000 100000
USD. POUND
EURO. JAPANESE YEN.
STERLING.
The exchange The exchange The exchange rate
The exchange rate in
Underlying / Order rate in Indian rate in Indian in Indian Rupees
Indian Rupees for US
Quotation Rupees for Rupees for for 100 Japanese
Dollars
Euro. Pound Sterling. Yen.
Tick size 0.25 paise or INR 0.0025
Monday to Friday
Trading hours
9:00 a.m. to 5:00 p.m.
Contract trading cycle 12 month trading cycle.
Two working days prior to the last business day of the expiry month at
Last trading day
12:30 pm.
Last working day (excluding Saturdays) of the expiry month.
16 Final settlement day The last working day will be the same as that for Interbank Settlements in
Mumbai.
Order book snapshot for Index
futures
17
Positions in futures contracts
⚫ Long position
⚫ Outstanding or unsettled ‘buy’ position
⚫ E.g.- If Mr. A buys 2 lots of Nifty futures on June 4, he has a
long position in Nifty futures
⚫ Short position
⚫ Outstanding or unsettled ‘sell’ position
⚫ E.g.- If Mr. B sells 2 lots of Nifty futures on June 3, he has a
short position in Nifty futures
⚫ Open position
⚫ Outstanding or unsettled long or short positions in any
derivatives contract
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Payoff for long futures position taken
at Rs.100
Payoff table Payoff diagram
Long position at 100
Price at expiry Long payoff
50 -50
60 -40
70 -30
80 -20
90 -10
100 0
110 10
120 20
130 30
140 40 A long position benefits from a
150 50
rise in price of the underlying
Profit to long = Spot price at
maturity – Original futures price
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Payoff for short futures position taken
at Rs.100
Payoff table Payoff diagram
Short position at 100
Price at expiry Short payoff
50 50
60 40
70 30
80 20
90 10
100 0
110 -10
120 -20
130 -30 A short position benefits from a
140 -40
150 -50 fall in price of the underlying
Profit to short = Original
futures price - Spot price at
maturity
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Question
⚫ Ajay takes a short position in 10 lots of Nifty futures at
23502 and squares up his position at 23448. If the
contract size is 25, he makes:
⚫ A loss of Rs.540
⚫ A loss of Rs.1350
⚫ A gain of Rs.13,500
⚫ A gain of Rs.540
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How to exit a futures position
⚫ Hold the position till contract expiry date when it is
automatically closed by the Exchange
⚫ This is known as final settlement
⚫ Close the position voluntarily before the contract expiry
date
⚫ This is known as ‘closing out’ or ‘squaring off’ or
‘unwinding’ the futures position
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Final settlement of a futures contract
⚫ Final settlement takes place on the expiry date of the
contract
⚫ Two methods of final settlement:
⚫ Delivery-based or ‘physical’ settlement and
⚫ Cash settlement
⚫ Delivery-based settlement involves taking delivery of the
underlying asset
⚫ Cash settlement is a solution to problems associated with
physical settlement; parties settle the difference in cash
and futures are used only for price-fixing and not for
taking delivery
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Final settlement of a futures contract
Methods of final
settlement
Delivery-based or
physical settlement Cash settlement
Individual stock futures Index futures and options,
& options, some currency futures and
commodity futures and options, volatility and
options weather derivatives
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Closing out or unwinding of a futures
position
⚫ Closing out means entering into an offsetting
position
⚫ A trader with an existing long position can square off the
position by entering a short position in the same contract
for the same quantity
⚫ A trader with an existing short position can square off by
entering into a long position in the same contract for the
same quantity
25
Why are futures positions closed out?
⚫ When settlement is inconvenient or costly
⚫ For traders: to book profit on a position which is in
profit
⚫ For traders: as a stop-loss for a position which is
losing money
⚫ Both hedgers and speculators can close out their
positions
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Example – closing out of position
On June 27, Ajay takes a long
position in 5 lots of July Nifty
futures contract at 23920
The contract is traded
at Rs.24215 on July 1.
Is Ajay’s position in a profit or
a loss? What should he do to
close out his position?
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Risk Management by the Exchange
⚫ Futures settlement will always result in loss to one party
⚫ How to ensure that losing party does not default?
⚫ Tools to manage the default risk
⚫ Clearing House
⚫ Margin deposits
⚫ Marking to market
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Clearinghouse of the Exchange
⚫ Clearinghouse is a part of the stock exchange
⚫ Concept of Novation
⚫ Ensures settlement of the trade in case of default by
either party
⚫ If buyer defaults, CH ensures that seller receives the funds
payout
⚫ If seller defaults CH ensures that buyer gets the securities
pay-out through auction mechanism
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Margin Requirements
⚫ Why are margins necessary?
⚫ Margins charged by Indian futures exchanges
⚫ Initial margin
⚫ Exposure margin
⚫ Daily Mark-to-market margin
⚫ ‘Marking-to- market’ is an accounting procedure that
forces both sides of the contract to take their gains/
losses daily
⚫ Prevents build-up of large unrealized “paper losses”
⚫ At the end of each day the position is re-priced at the
day’s settlement price and the contract is re-started
with a new base price
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Example - Daily MTM settlement
On June 3, 2024, a trader
takes a long position in
10 contracts of Nifty
futures expiring on June
27, 2024, at 23320.
Calculate his daily MTM
pay-in/pay-out on the
basis of the above data
The daily settlement price is usually the
weighted average of the last half-an-hour’s The position is closed on
trades in the futures contract June 7 at 23338.
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Example – Daily MTM settlement
Date Trade Contract Number Settlement MTM
price size of Price settlement
contracts
03-06-2024 23320.00 25 10 23407.90 21975.00
04-06-2024 21908.15 -374937.50
05-06-2024 22642.90 183687.50
06-06-2024 22899.50 64150.00
07-06-2024 23338.00 23325.15 109625.00
Total MTM settlement is the sum of daily MTM settlement which is Rs.4500
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Margin Cash Flows When Futures Price
Increases
Clearing House/Corporation
Clearing House Clearing House
Member Member
Broker/Trading Broker/Trading
Member Member
Long Trader Short Trader
33
Margin Cash Flows When Futures Price
Decreases
Clearing House/Corporation
Clearing Clearing
Member Member
Broker/ Trading Member Broker/ Trading Member
Long Trader Short Trader
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Leverage in futures contracts
⚫ Buying shares in spot market requires payment of full
consideration and thus involves large investment outlay
⚫ If the expected upward movement in the price does not
happen, substantial cash is locked up in the investment
and there is opportunity loss
⚫ Going long in the futures contract on the stock is a
viable alternative to buying shares in the spot market
⚫ Going long in a futures contract only requires deposit of
margins with the broker and payment of daily MTM
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Buying in the spot market ….
⚫ Mr A is bullish on ABC Ltd
⚫ He buys 5700 shares at the spot price of Rs. 550 on June 6
⚫ On June 7, Mr A makes payment of Rs. 31,35,000 and
receives delivery of 5700 shares
⚫ On June 19, Mr A sells off the shares at the spot price of
Rs.563
⚫ On June 20, Mr A receives consideration of Rs.32,09,100
and delivers 5700 shares
⚫ Profit on the transaction: Rs.74,100
⚫ Return on investment:2.36% over 13 days
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Buying stock futures…
⚫ Mr. A is bullish on ABC Ltd. Lot size of futures contract
is 1425
⚫ Mr. A buys 4 lots on June 6 at the futures price of Rs.552
by paying an initial margin of Rs.3,14,640
⚫ Daily MTM on the long position starts from June 6
⚫ On June 19, Mr. A squares off the long position at Rs.565
⚫ Mr A’s profit on the transaction: Rs.74,100
⚫ Return on investment:23.55% over 13 days
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