Foundation — Forwards, futures, contract specifications and the core terminology

15.1 Forwards

"A forward contract is an agreement made DIRECTLY BETWEEN TWO PARTIES to buy or sell an asset on a SPECIFIC DATE IN THE FUTURE, at the TERMS DECIDED TODAY. Forwards are widely used in commodities, foreign exchange, equity and interest rate markets."

The goldsmith example

"Assume that on May 11, 2024 you want to purchase gold from a goldsmith. The market price for gold on this day is Rs 62,130 for 10 grams of 24 carat gold... You pay him Rs 62,130... and take delivery. This is a CASH MARKET transaction at a price referred to as SPOT PRICE."

"Now suppose you do not want delivery... but only after 1 month. The goldsmith quotes you Rs 62,337 for 10 grams... Here, in this example, you have 'BOUGHT A FORWARD CONTRACT' or you are 'LONG FORWARD', whereas the goldsmith has 'SOLD A FORWARD CONTRACT' or he is 'SHORT FORWARD'. THERE IS NO EXCHANGE OF MONEY OR GOLD AT THIS POINT OF TIME. After 1 month, you come back..., pay him Rs 62,337 and take 10 grams of gold. This is a forward, where BOTH THE PARTIES ARE OBLIGED TO GO THROUGH WITH THE CONTRACT IRRESPECTIVE OF THE VALUE of the underlying asset at the time of delivery."

The outcomes: "if after one month the gold trades at Rs 62,700 in the cash market, the forward contract becomes favourable to you... net profit of Rs 363 per 10 grams. Similarly, if the spot price is 62,100 on that day, then you incur a loss of Rs 237 per 10 grams (= buy price – sell price)."

Essential features

• "It is a contract between TWO PARTIES (a BILATERAL contract)."
• "ALL TERMS of the contract like PRICE, QUANTITY AND QUALITY of underlying, DELIVERY TERMS like PLACE, SETTLEMENT PROCEDURE, etc. are FIXED ON THE DAY OF ENTERING INTO THE CONTRACT."

"forwards are BILATERAL OVER-THE-COUNTER (OTC) transactions where the terms... are NEGOTIATED BETWEEN TWO PARTIES. ANY ALTERATION in the terms of the contract IS POSSIBLE IF BOTH PARTIES AGREE to it. ... The ESSENTIAL IDEA of entering into a forward is to FIX THE PRICE and thereby AVOID THE PRICE RISK."

The two major limitations

Liquidity risk. "Liquidity refers to the ability of the market participants to buy or sell the DESIRED QUANTITY of an underlying asset. As forwards are tailor-made contracts... other market participants MAY NOT BE INTERESTED in these contracts. Forwards are NOT LISTED OR TRADED ON EXCHANGES, which makes it difficult for other market participants to easily access these contracts... Therefore, it is VERY DIFFICULT FOR PARTIES TO EXIT from the forward contract BEFORE the contract's maturity."

Counterparty risk. "the risk of an ECONOMIC LOSS FROM THE FAILURE OF THE COUNTERPARTY to fulfil its contractual obligation." The chapter's illustration: A agrees to buy 100 kg of rice at Rs 40 per kg from B after 6 months. "After 6 months, if price of rice is Rs 50 in the market then B MAY DECLINE his obligation to deliver at Rs 40. Similarly, if price of rice falls to Rs 35 then A MAY PURCHASE FROM THE MARKET at a lower price, instead of honouring the contract. Thus, a party to the contract MAY DEFAULT ON HIS OBLIGATION IF THERE IS INCENTIVE TO DEFAULT. This risk is ALSO CALLED DEFAULT RISK OR CREDIT RISK."

"In addition..., there are several issues like LACK OF TRANSPARENCY, SETTLEMENT COMPLICATIONS as it is to be done directly between the contracting parties. A simple solution to all these issues is to BRING THESE CONTRACTS TO THE CENTRALIZED TRADING PLATFORM. THIS IS WHAT FUTURES CONTRACTS DO."

15.2 Futures

"Futures contracts were CREATED TO OVERCOME THE LIMITATIONS OF FORWARDS. A futures contract is an agreement made THROUGH AN ORGANIZED EXCHANGE to buy or sell a FIXED AMOUNT of a commodity or a financial asset ON A FUTURE DATE AT AN AGREED PRICE. In simple terms, futures are STANDARDISED FORWARD CONTRACTS THAT ARE TRADED ON AN EXCHANGE. THE CLEARING CORPORATION associated with the exchange GUARANTEES SETTLEMENT of these trades."

"A trader, who BUYS futures contract, takes a LONG POSITION and the one, who SELLS futures, takes a SHORT POSITION. The words BUY AND SELL ARE FIGURATIVE ONLY because NO MONEY OR UNDERLYING ASSET CHANGES HAND, between buyer and seller, WHEN THE DEAL IS ORIGINATED."

Features of futures

"In a futures market, THE EXCHANGE DECIDES ALL THE TERMS OF THE CONTRACT OTHER THAN PRICE:

• Contract between two parties THROUGH EXCHANGE
• CENTRALISED TRADING PLATFORM (i.e., Exchange)
• PRICE DISCOVERY through FREE INTERACTION of buyers and sellers
• MARGINS PAYABLE BY BOTH THE PARTIES
• QUALITY decided today (standardized)
• QUANTITY decided today (standardized)"

And their limitations

"As futures are standardized contracts introduced by the exchanges, they TOO have certain limitations in the context of LIMITED MATURITIES, LIMITED UNDERLYING SET, LACK OF FLEXIBILITY IN CONTRACT DESIGN and INCREASED ADMINISTRATIVE COSTS on account of MTM SETTLEMENT, etc."

15.3 Contract specifications

"The exchange decides ALL TERMS AND CONDITIONS of futures contracts OTHER THAN THE PRICE. These terms and conditions are known as 'CONTRACT SPECIFICATIONS'."

The chapter's Nifty futures quote as on 3 October 2025: instrument type Index futures; underlying Nifty 50; expiry 28 October 2025; open 24,950.40; high 25,020; low 24,878.60; closing price 25,006.60; underlying value 24,894.25.

Underlying instrument and underlying price. "The underlying price is the SPOT PRICE or the price at which the underlying asset trades IN THE CASH MARKET" — here 24,894.25.

Contract multiplier or contract size. "Futures contracts are traded in LOTS. The lot size or contract size... is DETERMINED BY THE EXCHANGE. Contract sizes are DIFFERENT for each stock and index... To arrive at the CONTRACT VALUE, we must MULTIPLY THE FUTURES PRICE WITH THE CONTRACT MULTIPLIER." With a lot size of 65: 65 × 24,894.25 — the chapter computes the value on the closing futures price as 65 × 25,006.60 = Rs 16,18,126.25 (using 24,894.25 in its arithmetic line).

The regulatory position: "The current stipulation is for such contracts to have a value between Rs 5 lakhs and Rs 10 lakhs. This limit was LAST SET IN 2015. Since then, broad market values and prices have INCREASED BY AROUND THREE TIMES. Given this, SEBI has decided that a derivative contract shall have a value NOT LESS THAN Rs 15 LAKHS at the time of its introduction... Further, the LOT SIZE shall be fixed in such a manner that the CONTRACT VALUE ON THE DAY OF REVIEW IS WITHIN Rs 15 LAKHS TO Rs 20 LAKHS. These changes will be effective from Nov 2024."

Contract cycle. "Index and stock futures contracts traded on the NSE follow a THREE-MONTH TRADING CYCLE", so on 3 October 2025 contracts are available for the near month (Oct), the next month (Nov) and the far month (Dec). "The BSE offers trading on MONTHLY AS WELL AS WEEKLY futures contracts."

Expiration day. "the day on which a derivative contract CEASES TO EXIST... On expiry date, ALL THE CONTRACTS ARE COMPULSORILY SETTLED. If a position is to be CONTINUED, then it must be ROLLED OVER to another futures contract of the same underlying. For a LONG position, this means SELLING THE EXPIRING CONTRACT AND BUYING THE NEXT CONTRACT. BOTH THE SIDES OF A ROLL OVER SHOULD BE EXECUTED AT THE SAME TIME."

"The Nifty and the Bank Nifty futures contracts and the stock futures contracts listed on the NSE expire on the LAST TUESDAY of the respective month (OR THE DAY BEFORE IF THE LAST TUESDAY IS A TRADING HOLIDAY)... A NEW CONTRACT... IS INTRODUCED ON THE TRADING DAY FOLLOWING THE EXPIRY DAY OF THE NEAR MONTH CONTRACT."

SEBI's key measures on expiry:

• "Uniform Expiry Days: Exchanges can only choose EITHER TUESDAY OR THURSDAY as the expiry day for ALL equity derivatives contracts."
• "Weekly Contracts: Each exchange can offer ONLY ONE BENCHMARK INDEX OPTIONS CONTRACT PER WEEK, and that too on the chosen expiry day."
• "Monthly Contracts: All other equity derivative contracts (benchmark index futures, non-benchmark index derivatives, single stock futures/options) must have a MINIMUM 1-MONTH TENOR."
• "These should expire on the LAST Tuesday or Thursday of the month, based on the exchange's chosen day."
• "Change in Expiry Day Requires SEBI Approval."

"NSE has chosen TUESDAY as its expiry day, and BSE has chosen THURSDAY, with SEBI-mandated regulatory oversight on expiry changes." The purpose: "to REDUCE MARKET CONCENTRATION RISK and CONTROL EXPIRY-DAY VOLATILITY in equity derivatives by regulating expiry days across stock exchanges."

Tick size. "the MINIMUM MOVE ALLOWED IN THE PRICE QUOTATIONS... Tick size for Nifty futures is 5 PAISA. BID price is the price the BUYER IS WILLING TO PAY and ASK price is the price at which the SELLER IS WILLING TO SELL."

Daily settlement price. "All open positions are settled DAILY based on the DAILY SETTLEMENT PRICE... which is calculated by the exchange on the basis of the LAST HALF-AN-HOUR WEIGHTED AVERAGE PRICE of that futures contract. Thus, the daily settlement price is DIFFERENT FOR EACH FUTURES CONTRACT of a different expiry month."

Final settlement price. "the price at which all open positions in the NEAR-MONTH futures contracts are FINALLY SETTLED on the EXPIRATION DAY... The final settlement price is the CLOSING PRICE OF THE RELEVANT UNDERLYING INDEX OR STOCK IN THE CASH SEGMENT on the last trading day of the futures contract."

Trading hours. "between 9.15 am and 3.30 pm from Monday to Friday." And a distinction worth holding: "TRADING HOLIDAYS are days on which NO TRADING IS POSSIBLE as the exchanges are CLOSED, while CLEARING HOLIDAYS are days on which the exchanges are OPEN, and TRADING IS POSSIBLE BUT NO CLEARING AND SETTLEMENT TAKES PLACE AS BANKS ARE CLOSED."

BSE Sensex futures

"The HIGH CORRELATION between the movements of the Sensex and Nifty enables market participants to trade in Nifty and Sensex futures as part of a PAIRS TRADING STRATEGY."

15.4 The essential terminology

Basis

"The DIFFERENCE BETWEEN THE SPOT PRICE AND THE FUTURES PRICE is called BASIS. If the FUTURES price is GREATER than spot price, basis for the asset is NEGATIVE. Similarly, if the SPOT price is GREATER than futures price, basis for the asset is POSITIVE."

The worked case: "On Oct 03, 2025, spot price < futures price, thus basis for Nifty futures is NEGATIVE (i.e., 24894.25 – 25006.60 = −112.35)."

"basis for a one-month contract would be DIFFERENT from the basis for two-or three-month contracts. Therefore, definition of basis is INCOMPLETE UNTIL WE DEFINE THE BASIS VIS-A-VIS A FUTURES CONTRACT... the DIFFERENCE IN THE BASIS of a one month futures contract and two months futures contract SHOULD ESSENTIALLY BE EQUAL TO THE COST OF CARRYING the underlying asset between first and second month. Indeed, this is the FUNDAMENTAL PRINCIPLE OF LINKING various futures and underlying cash market prices together."

And the rule that always holds: "whatever the basis is, positive or negative, IT BECOMES ZERO AT MATURITY of the futures contract... This happens because FINAL SETTLEMENT of futures contracts on last trading day TAKES PLACE AT THE CLOSING PRICE OF THE UNDERLYING ASSET."

Cost of carry

"Cost of Carry is the RELATIONSHIP BETWEEN FUTURES PRICES AND SPOT PRICES. It measures the STORAGE COST (in commodity markets) PLUS THE INTEREST that is paid to finance or 'carry' the asset till delivery, LESS THE INCOME EARNED on the asset during the holding period. For EQUITY derivatives, carrying cost is THE INTEREST PAID TO FINANCE THE PURCHASE LESS (MINUS) DIVIDEND EARNED."

The worked example: a share of ABC Ltd at Rs 100, borrowing at 6% per annum, held one year, with "200% dividend on its face value of Rs 1 i.e., dividend of Rs 2. Thus his NET COST OF CARRY = Interest paid – dividend received = 6 – 2 = Rs 4. Therefore, BREAK EVEN FUTURES PRICE for him should be Rs 104. It is important to note that COST OF CARRY MAY BE DIFFERENT FOR DIFFERENT PARTICIPANTS."

Margins

"As the exchange GUARANTEES the settlement of all the trades, TO PROTECT ITSELF AGAINST DEFAULT by either counterparty, IT CHARGES VARIOUS MARGINS FROM BROKERS. BROKERS IN TURN CHARGE MARGINS FROM THEIR CLIENTS."

Initial margin. "The amount one needs to DEPOSIT IN THE MARGIN ACCOUNT AT THE TIME OF ENTERING into a futures contract." The example: long Nifty futures for May expiry at 22,250 with a lot size of 25, so "The contract value = Nifty futures price × lot size = 22250 × 25 = Rs 5,56,250", and at 10 per cent, "the investor has to give him Rs 55,625 as initial margin."

Two rules follow: "BOTH BUYERS AND SELLERS of futures contract PAY INITIAL MARGIN, AS THERE IS AN OBLIGATION ON BOTH THE PARTIES TO HONOUR THE CONTRACT", and "the initial margin is DEPENDENT ON PRICE MOVEMENT of the underlying asset. As HIGH VOLATILITY assets carry MORE RISK, the exchange would charge HIGHER initial margin on them."

Marking to market. "In futures market, while contracts have maturity of SEVERAL MONTHS, PROFITS AND LOSSES ARE SETTLED ON DAY-TO-DAY BASIS – called MARK TO MARKET (MTM) SETTLEMENT. The exchange COLLECTS these margins from the LOSS-MAKING participants and PAYS to the GAINERS on day-to-day basis."

The worked case: bought at 22,250; the contract closed at 22,308.70; "the trader benefitted due to the 58.70 points gain... the trader's MTM gain for the day was Rs 58.70 × 25 = Rs 1,468. This money will be CREDITED to the trader's account and NEXT DAY THE TRADER'S POSITION WILL START FROM 22308.70 (for the purpose of MTM computation)."

Open interest and volume

"The OPEN INTEREST is the TOTAL NUMBER OF CONTRACTS OUTSTANDING (YET TO BE SETTLED) for an underlying asset. It is important to understand that number of long futures AS WELL AS number of short futures IS EQUAL TO THE OPEN INTEREST... ONLY ONE SIDE of contracts is considered while calculating open interest. THE LEVEL OF OPEN INTEREST INDICATES DEPTH IN THE MARKET."

"Volumes traded give us an idea about the MARKET ACTIVITY with regards to specific contract OVER A GIVEN PERIOD – volume over a day, over a week or month or over the entire life of the contract."

The chapter's four-day table makes the distinction concrete:

Price band

"Price Band is essentially the PRICE RANGE WITHIN WHICH A CONTRACT IS PERMITTED TO TRADE DURING A DAY. The band is calculated with respect to the PREVIOUS DAY'S CLOSING PRICE of a specific contract." So a previous close of Rs 100 with a 10 per cent band gives a range of Rs 90 to Rs 110. "On the FIRST TRADING DAY of the contract, the price band is decided based on the CLOSING PRICE OF THE UNDERLYING ASSET IN CASH MARKET." And: "Sometimes, bands are allowed to be EXPANDED at the discretion of the exchanges WITH SPECIFIC TRADING HALTS."

Positions

• Long position — "OUTSTANDING/UNSETTLED BUY POSITION in a contract."
• Short position — "OUTSTANDING/UNSETTLED SELL POSITION in a contract."
• Open position — "Outstanding/unsettled EITHER LONG (BUY) OR SHORT (SELL) position in various derivative contracts."
• Naked position — "a LONG OR SHORT POSITION IN ANY FUTURES CONTRACT WITHOUT HAVING ANY POSITION IN THE UNDERLYING ASSET."
• Calendar spread position — "a COMBINATION OF TWO POSITIONS IN FUTURES ON THE SAME UNDERLYING - LONG ON ONE MATURITY CONTRACT AND SHORT ON A DIFFERENT MATURITY CONTRACT."

"Calendar spread position is COMPUTED WITH RESPECT TO THE NEAR MONTH SERIES and BECOMES AN OPEN POSITION ONCE THE NEAR MONTH CONTRACT EXPIRES OR EITHER OF THE OFFSETTING POSITIONS IS CLOSED."

• Opening a position — "buying or selling a contract, which INCREASES client's open position."
• Closing a position — "buying or selling a contract, which essentially results in REDUCTION of client's open position... if he SELLS a contract which he had BOUGHT before, or he BUYS a contract which he had SOLD earlier."

15.5 Forwards versus futures