NISM Series XVI · Chapter 3: Commodity Futures

L1 · Foundation

Foundation — What a futures contract is, and how it differs from a forward

A futures contract as a legally binding, exchange-traded, standardised agreement; the eight-point comparison with forward contracts covering standardisation, counterparty credit risk, margins, daily settlement, delivery, anonymity and liquidity; what a long position and a short position mean; the delivery obligation on a short seller at expiry and the default penalty; and the six advantages of futures over forwards.

20 min read · Worth 15% of the paper · Written from pages 47–63 of the official NISM workbook · Updated 18 September 2026

Commodity futures — the basics

1. What a futures contract is

⚠️ "The BUYER ENTERS INTO AN OBLIGATION TO BUY, and the SELLER IS OBLIGED TO SELL, on the specific date."

Both sides are obliged. Neither has a choice at expiry. This is the single feature that separates a future from an option — and it is why a futures buyer can lose money, which an option buyer cannot.

⚠️ "Futures are STANDARDIZED IN TERMS OF SIZE, QUANTITY, GRADE AND TIME, so that EACH CONTRACT TRADED ON THE EXCHANGE HAS THE SAME SPECIFICATION."

2. What the contract must specify

"Commodity Futures contracts are HIGHLY UNIFORM AND ARE WELL-DEFINED. These contracts EXPLICITLY STATE:"

Element	What it fixes
⚠️ The commodities	"QUANTITY AND QUALITY OF THE GOODS that have to be delivered"
⚠️ Time and place	"AT A CERTAIN TIME AND PLACE (ACCEPTABLE DELIVERY DATE)"
⚠️ Manner	"IN A CERTAIN MANNER (METHOD FOR CLOSING THE CONTRACT)"
⚠️ Price fluctuations	"PERMISSIBLE PRICE FLUCTUATIONS (MINIMUM AND MAXIMUM DAILY PRICE CHANGES)"

That last phrase — irrespective of the actual price prevailing — is the whole point of the instrument. It is what makes a hedge a hedge.

Under a commodity futures contract, the seller agrees to deliver to the buyer:

⚠️ A SPECIFIED QUANTITY of a commodity
⚠️ Of a SPECIFIED QUALITY
⚠️ On a SPECIFIED DATE
⚠️ At a SPECIFIC PRICE
⚠️ At the SPECIFIED PLACE

3. Futures versus forwards — the eight differences

"While futures contracts and forward contracts SHARE MANY SIMILARITIES, they are also DIFFERENT IN MANY RESPECTS. Futures carry many advantages in terms of BROADER PARTICIPATION and hence A ROBUST PRICE DISCOVERY IN THE MARKETS IN A TRANSPARENT MANNER compared to forward contracts."

#	⚠️ FUTURES	⚠️ FORWARDS
1	⚠️ "Always traded on a RECOGNIZED EXCHANGE"	⚠️ "By nature, OVER THE COUNTER (OTC) contracts transacted between a given buyer and seller"
2	⚠️ "HIGHLY STANDARDIZED by the exchange in terms of QUANTITY, QUALITY, PLACE OF DELIVERY AND DELIVERY DATES. Specifications MADE AVAILABLE TO ALL"	⚠️ "CUSTOMIZED contracts suited to the SPECIFIC REQUIREMENTS of the buyer and seller, specifications of which WILL NOT BE MADE AVAILABLE TO THE PUBLIC"
3	⚠️ "Credit risk / settlement risk is ELIMINATED because THE CLEARING CORPORATION OF THE EXCHANGE BECOMES THE CENTRAL COUNTER-PARTY to all buyers and sellers and thereby GUARANTEES SETTLEMENT OF TRADE"	⚠️ "Credit risk is DIRECTLY RELATED TO THE CREDIT WORTHINESS OF THE BUYER AND SELLER and their ABILITY AND WILLINGNESS TO HONOUR THE CONTRACT. COUNTER-PARTY CREDIT RISK EXISTS and SETTLEMENT FAILURE IS ALWAYS A POSSIBILITY"
4	⚠️ "Taking a position REQUIRES MARGIN MONEY that is DETERMINED BY THE REGULATED MARKETPLACE"	⚠️ "GENERALLY, THERE ARE NO MARGINS. However, IF ONE OF THE PARTIES IS NOT COMFORTABLE, HE MAY REQUIRE A MARGIN FROM THE COUNTER PARTY"
5	⚠️ "SETTLED DAILY based on the CLOSING PRICES, and margins paid are ADJUSTED AGAINST DAILY PRICE MOVEMENTS"	⚠️ "SETTLED ONLY ON THE MATURITY DATE"
6	⚠️ "ONLY A FRACTION of futures contracts leads to ACTUAL PHYSICAL DELIVERY"	⚠️ "GENERALLY RESULT IN ACTUAL PHYSICAL DELIVERY unless specified otherwise"
7	⚠️ "Traded ONLY THROUGH AN EXCHANGE. Buyers and sellers REMAIN ANONYMOUS to the transaction"	⚠️ "An OTC contract involving buyer and seller WHO KNOW EACH OTHER and PRE-NEGOTIATE the terms"
8	⚠️ "HIGHLY LIQUID and can be CLOSED OUT EASILY"	⚠️ "Markets for forward contracts are NOT VERY LIQUID"

3.1 How the differences connect

These eight rows are not eight separate facts — they are one design decision playing out eight times.

Standardisation (row 2) is what makes anonymity possible (row 7). If every contract is identical, it does not matter who is on the other side — you are not buying from a person, you are buying a specification.

Anonymity is what makes liquidity possible (row 8). You can close out by taking the opposite position with anyone at all, because the clearing corporation nets it off. In a forward you would have to go back to the same counterparty and renegotiate.

And the clearing corporation (row 3) is what makes both safe — which is why margins (row 4) and daily settlement (row 5) exist. ⚠️ "A distinct feature of futures is that the contracts are MARKED TO MARKET DAILY, and the members must PAY/RECEIVE MARGIN EQUIVALENT TO THAT DAY'S LOSS/GAIN, if any. THIS WAY, THE POSSIBILITY OF DEFAULT ON THE SETTLEMENT DATE IS SIGNIFICANTLY REDUCED."

⚠️ "Also, THE EXCHANGE GUARANTEES ALL TRADES ROUTED THROUGH ITS MEMBERS, EVEN IN CASE OF DEFAULT, INSOLVENCY, OR NON-PERFORMANCE OF ANY CLIENT OR MEMBER."

4. Long and short

"Futures are BOUGHT AND SOLD ONLY THROUGH THE AUTHORIZED MEMBERS OF THE EXCHANGE."

4.1 The short seller's delivery obligation

"One may enter into a contract to sell the goods at the futures price on a future date, WITHOUT ANY EXISTING POSITION in a comparable long position in the futures market. This is called taking a 'SHORT POSITION'."

This is a real commodity-market difference from equity derivatives. A short position that is not squared off before expiry becomes an obligation to produce physical goods of the right grade at the right warehouse. "I meant to close it" is not a defence — it is a penalty.

5. Financial futures versus commodity futures

⚠️ "Futures contracts on CURRENCY RATES (currency futures), INTEREST RATES (bond futures) and EQUITY PRICES (stock or equity index futures) are known as FINANCIAL FUTURES, as distinct from COMMODITY FUTURES (futures on crude oil, metals, agriculture products, etc.)."

6. The six advantages of futures over forwards

⚠️ "EFFICIENT PRICE DISCOVERY as the market BRINGS TOGETHER BUYERS AND SELLERS OF DIVERGENT NEEDS"
⚠️ "ELIMINATION OF COUNTERPARTY CREDIT RISK as exchanges INTERPOSE AS CENTRAL COUNTER-PARTY"
⚠️ "ACCESS TO ALL TYPES OF MARKET PARTICIPANTS, BIG OR SMALL"
⚠️ "STANDARDIZED PRODUCTS: standardization INCREASES THE CLARITY about all factors that decide the price of a commodity and LEAVES IT TO THE FORCES OF SUPPLY AND DEMAND, thereby EASING PARTICIPATION resulting in INCREASED LIQUIDITY than the forward markets"
⚠️ "Being SCIENTIFICALLY MARGINED and margins representing A FRACTION OF THE COMMODITY'S TOTAL VALUE, it INCREASES THE PARTICIPANTS' COST-EFFICIENCY"
⚠️ "TRANSPARENT TRADING PLATFORM INDUCES CONFIDENCE among participants"

7. Pay-off — the idea in one line

"PAY-OFF refers to PROFIT OR LOSS IN A TRADE. A pay-off is referred to as 'POSITIVE' if the trade results in a PROFIT and 'NEGATIVE' if it results in a LOSS. A PAY-OFF DIAGRAM REPRESENTS PROFIT/LOSS IN THE FORM OF A GRAPH."

⚠️ "The pay-off of a futures contract on maturity DEPENDS ON THE SPOT PRICE OF THE UNDERLYING GOODS AT EXPIRY AND THE PRICE AT WHICH THE CONTRACT WAS INITIALLY TRADED."

The two formulae — learn them as a mirrored pair:

Position	Formula
⚠️ LONG	⚠️ Pay-off = ST − F
⚠️ SHORT	⚠️ Pay-off = F − ST

where ST is "the spot price of the asset at the expiry of the contract (i.e. the closing price on the expiry date)" and F is "the futures contracted price".

It is a zero-sum transfer between the two sides. Every rupee the long makes is a rupee the short loses.

Think of it like this

The tailor-made suit and the ready-made shirt

A tailor in Ahmedabad stitches you a suit to your exact measurements — sleeve length, shoulder drop, the pocket where you want it. That is a forward contract. It fits you perfectly and nobody else. If you change your mind next week, you cannot sell it to a stranger; the trousers will not fit them.

A shirt from a showroom comes in 38, 40, 42. It does not fit you as perfectly as the tailored one. But because thousands of people wear size 40, there is a market for size 40 — you can exchange it, resell it, compare prices across five shops.

⚠️ This is exactly the trade-off in row 2 and row 8 of the comparison table. Forwards are "customized contracts suited to the specific requirements of the buyer and the seller" — and so "markets for forward contracts are not very liquid." Futures are "highly standardized in terms of quantity, quality, place of delivery and delivery dates" — and so they are "highly liquid and can be closed out easily."

You give up a perfect fit and you buy back the ability to walk away.

The escrow agent at a property sale

When two strangers buy and sell a flat, neither wants to hand over first. So both go to an escrow agent. The buyer's money and the seller's papers both sit with the agent, who releases each side only when both have performed. Neither party now needs to trust the other — they only need to trust the agent.

⚠️ The clearing corporation is that agent, permanently. It "becomes the CENTRAL COUNTER-PARTY to all the buyers and sellers and thereby GUARANTEES SETTLEMENT OF TRADE." In a forward, "credit risk is directly related to the credit worthiness of the buyer and seller and their ability and willingness to honour the contract" — you are back to trusting a stranger.

Notice what this buys you: it is precisely because the clearing corporation stands in the middle that buyers and sellers can "remain anonymous to the transaction." You do not need to know who sold you the contract, because you are not relying on them at all.

Paying the electricity bill monthly instead of once a year

Suppose your electricity board sent one bill at the end of the year. Some households would run up a bill they cannot possibly pay, and the board would discover this only in month twelve — when nothing can be done.

Monthly billing catches the problem in month one. The amount at risk never grows large enough to be unpayable.

⚠️ That is daily mark-to-market. Futures are "settled daily based on the closing prices in the markets and the margins paid are adjusted against daily price movements." Forwards are "settled only on the maturity date."

"THIS WAY, THE POSSIBILITY OF DEFAULT ON THE SETTLEMENT DATE IS SIGNIFICANTLY REDUCED."

The loss does not become smaller. It just never gets a chance to accumulate in silence.

Two people betting on the same cricket score

Ramesh bets Suresh that India will score above 280. If India makes 320, Ramesh wins exactly what Suresh loses. There is no third source of money in the room. Whatever one gains, the other funds.

⚠️ A futures contract works identically. "As one person goes long, some other person has to go short, otherwise a deal will not take place. THE PROFITS AND LOSSES FOR THE SHORT FUTURES POSITION WILL BE EXACTLY OPPOSITE OF THE LONG FUTURES POSITION."

Long pay-off = ST − F. Short pay-off = F − ST. Add them together and you always get zero.

This is worth sitting with, because it explains something students often find puzzling — why the exchange does not "lose money" when prices crash. It never had a position. It only guaranteed that the winner gets paid by the loser.

The obligation that does not care what you meant

A wedding caterer signs to deliver food for 500 people on 15 December. On 14 December he realises he has double-booked. His intention to cancel is irrelevant — he must either deliver or pay damages.

⚠️ A short futures position in commodities is the same. "The open short position in futures ON EXPIRY NEEDS TO BE DELIVERED by buying from the spot market or from one's existing stock, ensuring that THE QUANTITY AND THE QUALITY MEETS THE FUTURES CONTRACT SPECIFICATIONS."

"IF THE SHORT SELLER DOES NOT DELIVER, IT WILL END UP BEING NON-COMPLIANT TO HIS CONTRACTUAL OBLIGATIONS LEADING TO THE DELIVERY DEFAULT, WHICH WILL RESULT IN AN OBLIGATION TO PAY UP THE DELIVERY DEFAULT PENALTY."

The trap here catches equity traders moving to commodities. A short in a cash-settled index simply settles in money. A short in a commodity futures contract that reaches expiry becomes a truck of goods of the right grade at the right warehouse.

The train ticket you booked in advance

You book a Rajdhani ticket in April for a journey in June at Rs 3,200. In June, tatkal fares are Rs 5,000. You still travel at Rs 3,200. Had fares fallen to Rs 2,500, you would still pay Rs 3,200 — and you would feel foolish.

⚠️ That is the futures obligation in a sentence. Futures "provide for the delivery of a physical commodity at the ORIGINALLY CONTRACTED AMOUNT on a specified future date, IRRESPECTIVE OF THE ACTUAL PRICE THAT MAY BE PREVAILING ON THE ACTUAL DATE OF DELIVERY."

And that "irrespective" is not a defect — it is the entire product. A hedger is buying certainty, and certainty necessarily means giving up the good outcome along with the bad one. Someone who wants only the good outcome is describing an option, and will be charged a premium for it.

Key terms in this chapter

Annual compounding formula: F = S × (1 + r)^n, where r is the annually compounded cost of financing and n is time to expiry in years.
Backwardation: A market where the futures price is below the spot price, suggesting participants expect the spot price to fall. It occurs in spite of cost of carry — from seasonality in agri commodities, and from gloomy demand expectations or supply glut in non-agri commodities.
Bootstrapping: The methodology used to remove extreme polled prices. A median is arrived at, outliers are ignored, and an algorithm then finds the price with the least standard deviation against the remaining polled data.
Central counter-party: The clearing corporation of the exchange, which stands between every buyer and every seller and guarantees settlement. Its presence is what eliminates counterparty credit risk in futures, unlike forwards.
Contango: A market where the futures price is higher than the spot price, suggesting participants expect the spot price to rise. A depreciating local currency can also produce it in globally traded or imported commodities.
Continuous compounding formula: F = S × e^(r × n), where e equals 2.71828. Used when no storage costs are involved. It always gives a slightly higher fair value than discrete compounding at the same rate.
Convenience yield: The benefit in rupee terms that a user realises for carrying sufficient stock of physical goods over and above immediate needs. It is one of the differentiating features between financial and commodity derivatives.
Convergence: The narrowing of the gap between spot and futures prices as expiry approaches. Because cost of carry diminishes every day and reaches zero on the delivery date, the two prices merge at maturity.
Cost of carry: The cost of holding a commodity from today until the futures expiry — storage, insurance, transportation, financing and other associated costs. It is the additional price a futures buyer pays over the spot buyer.
Delivery default penalty: The penalty payable when a short seller with an open position at expiry fails to deliver goods matching the contract's quantity and quality specifications. In commodities, an unclosed short becomes a real delivery obligation.
Empanelled polling participants: The traders and users of a commodity from whom spot prices are collected. Exchanges review the panel regularly, adding active participants and removing inactive ones.
Ex-warehouse price: The basis on which agri spot prices are polled — inclusive of mandi cess but exclusive of GST.
Fair value: The theoretical value of a futures contract given the current spot price, the cost of financing and the time till expiry. If the actual spread differs from the cost of carry, one of the two markets becomes the cheaper way to acquire the commodity.
Final Settlement Price (FSP): The simple average of the polled spot prices of the last three days including expiry day — E, E-1 and E-2. It matters for cash settlement of a contract and for delivery default by a short seller.
Financial futures: Futures on currency rates, interest rates and equity prices — as distinct from commodity futures on crude oil, metals and agricultural products.
Forward contract: An over-the-counter contract customised to the specific requirements of one buyer and one seller, whose specifications are not made public. It settles only on the maturity date and generally results in actual physical delivery.
F = S + C: The cost-of-carry model. Futures price equals spot price plus cost of carry. With convenience yield included it becomes F = S + C − Y.
F = S + C − Y: The futures pricing equation revised for convenience yield. Cost of carry pushes the futures price up; convenience yield pulls it down, and when Y exceeds C the market falls into backwardation.
FSP fallback methods: When polling data is missing, SEBI allows averaging whatever is available going back to E-3 provided the E day price exists. If the E day price is missing, NCDEX uses in order: an alternate basis-centre price, extrapolation from the last 30 days' futures-spot trend, futures prices of the last three days after removing outliers, and finally the last available polled spot price.
Futures contract: A legally binding agreement entered on an exchange to buy or sell a specified amount of an asset at a certain future time for a price agreed today. The buyer is obliged to buy and the seller is obliged to sell — neither has a choice at expiry.
Long position: Buying futures — also called going long. The long profits when the spot price at expiry exceeds the price contracted. Pay-off = ST − F.
Mark to market: Settling futures contracts daily against closing prices, with members paying or receiving margin equal to that day's loss or gain. It stops losses accumulating in silence until maturity.
m-times compounding formula: F = S × (1 + r/m)^(m × n), where m is the number of compounding periods a year — 2 for semi-annual, 4 for quarterly, 12 for monthly.
Pay-off: The profit or loss on a trade — positive if a profit, negative if a loss. Commodity futures have a linear pay-off, and long and short pay-offs are exact mirror images, so the two sides together net to zero.
Principle of least error: The basis of the polling algorithm — the final polled price is the one with the least standard deviation versus the set of polled prices, similar to the least square method of regression.
Quotation factor: The number of units the quoted price refers to — 10 for gold quoted per 10 grams, 1 for zinc quoted per kilogram. It is the divisor in the tick value formula.
Seasonality effect: During sowing season spot supplies are tight and prices high; the harvest three to four months later brings more supply, so the three-month futures is priced below current spot.
Short position: Selling futures without an existing long position — also called going short or shorting. The short profits when prices fall. Pay-off = F − ST.
Spot price polling: The process of compiling price information from a cross-section of market players at different centres across the country, to arrive at a daily spot price for dissemination.
Standardisation: Fixing size, quantity, grade and time so every contract on the exchange has the same specification. This is what allows buyers and sellers to remain anonymous, and what makes futures liquid enough to close out easily.
Tick size: The minimum price movement permitted in a contract, expressed in rupees or paise for a unit commonly used in the physical market. It differs from one commodity to another.
Tick value: The rupee worth of a one-tick move on the contract, calculated as (lot size / quotation factor) × tick size. Gold: (1,000/10) × 1 = Rs 100. Zinc: (5,000/1) × 0.05 = Rs 250.

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Original explanatory writing based on the official NISM workbook for Series XVI, which is published and copyrighted by NISM. Check figures against the current edition at nism.ac.in.

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