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Forwards and Futures


The emergence of the market for derivative products can be traced back to the willingness of risk-
averse economic agents to guard themselves against uncertainties arising out of fluctuations in asset
prices. Thus, derivative products initially emerged as hedging devices against fluctuations in
commodity prices. Commodity linked derivatives remained the sole form of such products for almost
three hundred years.

According to the Securities Contracts (Regulation) Act, 1956, derivatives are those
assets whose value is determined from the value of some underlying assets. The
underlying asset may be equity, commodity or currency. A common place where such
transactions take place is called the derivative market.

Financial products commonly traded in the derivatives market are themselves not primary loans or
securities. But can be used to change the risk characteristics of underlying asset or liability position,
they are referred to as 'derivative financial instruments' or simply 'derivatives.'

These financial instruments are so called because they derive their value from some underlying
instrument and have no intrinsic value of their own. The world over, derivatives are a key part of the
financial system.

Figure 1 displays the classification of derivatives.

Contracts Future

Baskets Derivative Options

Leaps Swaps

Figure 1. Classification of Derivatives

In this unit, we will discuss in detail about different types of derivatives.

Forward Contracts

A forward contract is an agreement made today between a buyer and a seller to

exchange the commodity or instrument for cash at a predetermined future date at a
price agreed upon today. The agreed upon price is called the forward price.
With a forward market, the transfer of ownership occurs on the spot, but delivery of the commodity or
instrument does not occur until some future date. In a forward contract, two parties agree to do a trade
at some future date, at a stated price and quantity. No money changes hands at the time the deal is

A wheat farmer may wish to contract to sell their harvest at a future date to eliminate the risk of a
change in prices by that date. Such transaction would take place through a forward market.

Forward contracts are not traded on an exchange, they are said to trade Over the Counter (OTC). The
quantities of the underlying asset and terms of contract are fully negotiable. The secondary market
does not exist for the forward contracts and faces the problems of liquidity and negotiability.

Features of Forward Contracts

The following are the features of forward contracts.

1. Custom tailored
2. Traded over the counter (not on exchanges)
3. No money changes hands until maturity
4. Non-trivial counter-party risk

Consider a 5-month forward contract for 1,000 tons of castors at a forward price of
Rs. 255 per ton. The long side is committed to buy 1,000 tons of castors from the short side in five
months at the price of Rs. 255 per ton.

Futures Contracts

The futures contract is traded on a futures exchange as a standardised contract, subject

to the rules and regulations of the exchange. It is the standardisation of the futures
contract that facilitates the secondary market trading.
The futures contract relates to a given quantity of the underlying asset and only whole contracts can
be traded. The trading of fractional contracts is not allowed in futures contracting. The terms of the
futures contracts are not negotiable.

A futures contract is a financial security, issued by an organised exchange to buy or sell a commodity,
security or currency at a predetermined future date at a price agreed upon today. The agreed upon
price is called the ‘futures price’.

Features of Futures Contracts

The following are the features of futures contracts.

1. Standardised contracts:

(a) underlying commodity or asset

(b) quantity
(c) maturity
2. Exchange traded
3. Guaranteed by the clearing house – no counter-party risk
4. Gains or losses settled daily
5. Margin account required as collateral to cover losses

Yesterday, Jammy bought ten ‘December live-cattle’ contracts at CME, at a price of Rs. 0.7455 per pound.
The following are the details related to contract.

 Contract size 40,000 lb

 Agreed to buy 400,000 pounds of live cattle in December

The value of position yesterday: (0.7455)(10)(40, 000) = Rs. 298, 200.

Assuming, no money changed hands and the initial margin required (5%-20% of contract value), today, the
futures price closes at Rs. 0.7435/lb.

The value of position today (at the future price of Rs. 0.7435/lb) is calculated as:

(0.7435)(10)(40, 000) = Rs. 297, 400 (that is, a loss of Rs. 800)

We can infer that:

 Standardisation makes futures liquid

 Margin and marking to market reduce default risk
 Clearing-house guarantee reduces counter-party risk

Futures vs. Forward

Forward contracts are private bilateral contracts and have well-established commercial usage. Futures
contracts are standardised tradable contracts fixed in terms of size, contract date and all other features.
Table 6.1 lists the differences between forward and futures contracts.

Table 1. Forward Contracts vs. Futures Contracts

Forward contracts Future contracts
1. The contract price is not 1. The contract price is transparent.
publicly disclosed and hence not
2. The contract is exposed to default 2. The contract has effective
risk by counterparty. safeguards against defaults in the
form of clearing corporation
guarantees for trades and daily mark
to market adjustments to the
accounts of trading members based
on daily price change.
3. Each contract is unique in 3. The contracts are standardised in
terms of size, expiration date terms of size, expiration date and all
and asset type/quality. other features.
4. The contract is exposed to 4. There is no liquidity problem in
the problem of liquidity. the contract.
5. Settlement of the contract is done by 5. Settlement of the contract is done
delivery of the asset on the on cash basis.
expiration date.

Types of Futures

Futures contracts can be classified into four categories. They are:

• Interest Rate Futures

• Index Futures
• Currency Futures
• Commodity Futures

Interest Rate Futures

Interest rate futures are based on an underlying security which is a debt obligation. An interest rate
future moves in value according to the changes in the interest rates.

In a market condition in which the interest rates are moving higher, the futures contract buyer has to
pay the seller an amount equal to that of the profit accrued by investing at a higher rate in comparison
to that of the rate specified in the futures contract.

On the contrary, when interest rates move lower, the futures contract seller compensates the buyer for
the lower interest rate at the time of expiration.

An interest rate futures price index was created in order to accurately determine the gain or loss of an
interest rate futures contract. In the condition of buying, the index is calculated by subtracting the
futures interest rate from 100 (which can be mathematically written as 100 – Futures Interest Rate).
This price index fluctuates in accordance with the interest rates.

In other words, when the interest rates increase, the index will move lower and vice versa. Examples
include Treasury-bill futures, Treasury-bond futures and Eurodollar futures.

By now, it is quite clear that the interest rate futures are used to hedge against the risk of the interest
rates that will move in an adverse direction, causing a cost to the company. Typically, the interest rate
futures contract has 1 basis point or base price move (tick) of 0.01. Nevertheless, certain contracts
have a tick value of 0.005 or half of 1 basis point.

Solved Problem - 1

A T-bond with an annual coupon rate of 7% (with semi-annual coupon payments) is selling at par.
If the current short rate is 5%, what would be the 6-month forward price of the T-bond?


Table 6.2 displays the cash flow particulars of T-bond.

Table 6.2. Cash flow Particulars of T-bond

Time 0 1 2 3
Buy T-bond –100.0 3.5 3.5 3.5
Sell T-bill 100.0 – 102.5 0 0
Net 0 – 99.0 3.5 3.5

This strategy allows one to lock in a purchase of the 7% T-bond 6-month later for $ 99. No
arbitrage requires the current forward price to be $ 99.

In general, a bond’s forward price is calculated as shown in equation 6.1.

F =S(1 + r − y) -------- Eq. 6.1


• S = T-bond’s spot price

• r = Spot interest rate
• y = C/S = T-bond’s coupon yield

Index Futures

Index or Stock index futures are one of the varieties of futures contracts. The first stock index futures
contract based on value line index were introduced by Kansas City Board of Trade (KCBT) on 24th
February, 1982. Two months later, the Standard and Poor (S&P) 500 Index futures contract was
introduced by the Chicago Mercantile Exchange (CME).

At present, S&P 500 Index Futures is the most actively traded futures contract. Table 6.3 displays the
stock index futures that are the most actively traded financial derivatives in the world.

Table 6.3. Stock Index Futures

S. No. Country Stock Name
2. US DJIA, S&P 500, NYSE, RUSSELL 2000,
3. Japan NIKKEI
4. Germany DAX
5. UK PTSE 100
6. France CAC 40
7. Switzerland SMI
8. Spain IBEX 35
9. Canada TSE 35
10. Hong Kong HANGSENG
11. Malaysia KUALALUMPUR
12. South Korea KOSPI 2000
Trading in Stock Index Futures
Trading in Sensex or Nifty futures is just like trading in any other security. An investor is able to buy
or sell futures on the BSE – Bolt terminal or the NSE – NEAT screen with his broker. In the trading,
the order will have to be punched in the system. The confirmation from the system will be immediate
like the existing system. Since the tick size and market lot size in futures are similar to individual
stock, the feel of trading in stock index futures is the same as trading on stocks.

Separate bids and ask quotations are available like shares. Simply, the investor has to punch in the
order of the required quantity at a price he wishes to buy, sell or execute the same at the market price.
Upon execution of the order he would receive a confirmation of the same. A trader can carry the stock
index futures contract till maturity or square it off at any time before expiry.

Pricing of Stock Index Futures

Contract theoretical or fair price of a stock index futures contract is derived from the well-celebrated
cost of carry model.

Accordingly, the stock index futures price depends upon:

i. Spot index value

ii. Cost of carry or interest rate
iii. Carry return, that is, dividends expected on securities comprising the index

Speculation in Stock Index Futures Trading

An investor can speculate by trading in stock index futures based on his expectations of market rise or
market fall. Suppose an investor expects the market to rise then he can buy stock index futures.

Hedging with Stock Index Futures

Hedging technique is very useful in the case of high net worth entities such as mutual funds having a
portfolio of securities. For instance, if the investor wants to reduce the loss on his holding of securities
due to uncertain price movements in the market, he can sell futures contracts.

Reasons for Popularity of Stock Index Futures

Stock index futures are the most preferred derivatives in India owing to the undernoted reasons:

1. The portfolio hedging is given priority by the institutional and other enormous equity-
2. The most cost-efficient hedging is the stock index futures.
3. Stock index is almost beyond the scope of manipulation, whereas it is very easy to
manipulate the individual stock price (Instances such as, manipulation of individual stock
prices of Reliance Industries Ltd. and the State Bank of India by some interested parties,
are recorded in history).
4. The most liquidity featured stock index futures are most popular in India and abroad.
5. The remote possibility of bankruptcy in stock index futures has been guaranteed by the
clearinghouse effects.
6. The individual stock futures are always used for manipulating their prices in cash
7. The less volatility featured stock index futures have lowered the requirement of capital
adequacy and margin in comparison to individual stock futures.
8. The regulatory framework for stock index futures ensures less complexity and hence,
the popularity for equity derivatives is growing.

Stock index futures offer implementation advantages and incremental returns to portfolios only
because of the fact that some useful strategies are available for institutions using stock index futures.

There are a number of useful strategies available for institutions using stock index futures.

1. The benefit of the lowest possible transaction costs is attractive.

2. The actual disposing of equity holdings may be made gradually subject to the market conditions.
3. The low commission rate on stock index futures trading and the high level of liquidity in stock index
futures market offer the potential for significant savings.
4. Stock index futures offer an attractive strategy for maintaining the desired stock market exposure of
the portfolio at all points of time.
5. Stock index futures are strategically used for insuring against market risks.
6. Stock index futures offer an effective ‘beta’ control to the portfolio manager for having the following

i. Optimal stock mix

ii. Considerable lower transaction costs
iii. Achieving the portfolio target ‘beta’ through buying targeted futures

7. Stock index futures offer the most productive as well as effective asset allocation strategy to the
portfolio manager in order to maximise the investors’ wealth by minimising the market risks.
8. The market volatility can be effectively managed by stock index futures by making transactions with
greater speed with lower implementation cost.
9. The market disruptions caused by the external investment managers can effectively be reduced with
the strategic use of stock index futures.
10. The most important advantage of stock index futures is that less money needs to be involved to alter
the asset-mix due to the leveraged impact of contracts.

Solved Problem - 2

The following data relates to ABC Ltd.’s share prices.

• Current price per share = Rs. 180

• Price per share in the futures market-6 months = Rs. 195

It is possible to borrow money in the market for securities transactions at the rate of 12% per

i. Calculate the theoretical minimum price of a 6-month forward contract.

ii. Explain if any arbitraging opportunities exist.


i. Calculation of theoretical minimum price of a 6-month forward contract:

Current share price Rs. 180

Interest rate prevailing in money market for securities transactions 12%

Theoretical Minimum Price = Rs.180 + (Rs.180 × 12/100 × 6/12) Rs.190.80

ii. Arbitraging opportunities

The current price per share in the futures market for 6 months is Rs. 195 and the
theoretical minimum price of 6-month forward is Rs. 190.80.

The arbitrage opportunities exist for ABC Ltd.’s share. An arbitrageur can invest in
ABC Ltd.’s shares at Rs. 180 by borrowing at 12% p.a. for 6 months and at the same
time he can sell the shares in the futures market at Rs. 195.

On the expiry date, that is, after 6 months period, the arbitrageur can collect Rs. 195 and
pay off Rs. 190.80 and can record a profit of Rs. 4.20 (that is, Rs. 195 – Rs. 190.80).

Currency Futures

Currency future, is a futures contract to exchange one currency for another at a

specified future date at a price (exchange rate) fixed on the purchase date.

More popularly, currency future is called as foreign exchange future or FX future. Usually, one of the
currencies of exchange in such contracts is US dollar. The price of the futures contract of this type is
hence measured in terms of US dollars per unit of other currency.

The trading unit of each contract is a particular amount of the other currency, for example, Rs.
290,000. Most of the currency futures contracts have a physical delivery, so as to make the actual
payments of each currency for those held at the end of the last trading day.

Nevertheless, most contracts get closed even before the end of the last trading day. This means that
the investors can close out the contract at any time before the contract's delivery date.

Currency futures contracts are similar to the currency markets, but there are certain significant
differences between them. One such difference is that the currency futures are traded through
exchanges, such as the Chicago Mercantile Exchange (CME), but the currency markets are traded
through currency brokers. Thus, the currency markets are not as controlled as the currency futures.

While the traders prefer the currency markets on certain days, the currency futures become their
favourites on the other. The currency futures are recommended as they do not suffer from some of the
problems that currency markets suffer from. For example, the problems may be from the currency
brokers trading against their clients, and may be due to non centralised pricing.

Settlement and Delivery of Currency Futures

Since currency futures are based upon the exchange rates of two different currencies, they are settled
in the underlying currency in the form of cash.

The EUR futures market has the Euro as its underlying currency and is based upon the Euro to US
Dollar exchange rate. When an EUR futures contract expires, the holder thus receives the delivery
worth Euros in cash. This happens only when the contract expires.
The day traders do not usually hold futures contracts until they expire. The day traders are generally
not involved in the settlement. Therefore, they do not receive delivery of the underlying currency.

Popular Currency Futures

Table 4 displays the most popular currency futures markets.

Table 4. Popular Currency Futures Markets

Name Description
EUR The Euro to US Dollar currency future
GBP The British Pound to US Dollar currency future
CHF The Swiss Franc to US Dollar currency future
AUD The Australian Dollar to US Dollar currency future
CAD The Canadian Dollar to US Dollar currency future
RP The Euro to British Pound currency future
RF The Euro to Swiss Franc currency future

Commodity Futures

Commodity futures can be defined as those futures where the underlying is a

commodity or physical asset.

The underlying commodity can be wheat, cotton, butter, eggs and so on. Such contracts began trading
on Chicago Board of Trade (CBOT) in 1860s. In India too, futures on soya bean, black pepper and
spices have been trading for long.

For commodity futures:

• Contango means the spot prices are lower than futures prices and/or the prices for near
maturities are lower than for distant.

• Backwardation means the spot prices are higher than the futures prices and/or the prices
for near maturities are higher than for distant.

Standardisation of Contracts

Since futures are traded on exchange, so future contracts are always standardised, that is, they must
specify the asset. This standardisation includes:

• How much asset is to be delivered under one contract

• Where delivery will be made
• When delivery will be made

In principle, the parameters to define a contract are endless (see for instance in futures contract).
There are only a limited number of standardised contracts to make sure that the liquidity is high.

The standardised items in any futures contract are:

i. Quantity of the underlying

ii. Quality of the underlying (not required in financial futures)
iii. The date and month of delivery
iv. The units of price quotation (not the price itself) and minimum change in price (tick-size)
v. Location of settlement

Thus, it becomes imperative that standardisation enhances liquidity, and makes it possible to trade the
same instrument for large numbers of participants in the market. This liquidity consequently makes
the contract more useful for hedging.

Remember that the standardisation also reduces the usefulness of a futures

contract as a merchandising vehicle.

Minimum Price Fluctuation

Financial markets move in different sizes of price increments, and the minimum price
fluctuation is known as a tick.

Futures markets often have specific tick sizes, unlike the stock markets that have a tick size of 0.01,
which is the equivalent of $ 0.01 for US stock markets. Tick sizes and tick values are part of the
contract specifications for all financial markets.

Tick Size

A market's tick size is the minimum amount that the price of the market can change.

The minimum price fluctuation in the value of a contract, that is, the tick size, is presently "0.05" or
5 paisa. In Rupee terms, this translates to a minimum price fluctuation of Rs. 0.75 for a single
transaction of SENSEX Futures Contract

(Tick size X Contract Multiplier = 0.05 X Rs. 15);

The EUR futures market has a tick size of 0.0001, which means that the smallest increment that the
price can move from 1.2902, would be up to 1.2903, or down to 1.2901.

Tick Value

A market's tick value is the cash value of one tick (one minimum price movement).

The EUR futures market has a tick value of $ 12.50, which means that for every 0.0001 that the
price moves up or down, the profit or loss of a trade would increase or decrease by $ 12.50.
The tick size is also known as the minimum price movement. The tick value is also
known as the minimum price value.

Profit and Loss Potential

Each day, the trading market has a different tick size (the smallest increment that the price can move),
and tick value (the amount of money per tick size). The higher the tick value, the more money is made
or lost with each price movement. So at the beginning of the day, traders need to trade markets that
have low to medium tick values.

Table 5 displays some popular day trading markets that have tick sizes and tick values low enough for
beginning day traders.

Table 5. Tick Sizes and Tick Values of Popular Day Trading Markets
Currency Futures  EUR: The Euro futures market has a tick
value of $ 12.50
 GBP: The British Pound futures market has a
tick value of $ 6.25
Stock Index Futures  YM: The Dow Jones futures market has a tick
value of $5.00
 ES: The S&P 500 futures market has a tick
value of $12.50
 ER2: The Russell 2000 futures market has a
tick value of $10.00
 CAC40: The CAC40 futures market has a tick
value of 5.00 EUR
 HSI: The Hang Seng futures market has a tick
value of 50.00 HKD
Commodity Futures  ZG: The Gold 100 troy ounce futures market
has a tick value of $10.00
 ZI: The Silver 5000 ounce futures market has
a tick value of $5.00
Agricultural Futures  ZC: The corn futures market has a tick value
of $12.50
 ZW: The wheat futures market has a tick
value of $12.5

One popular futures market that is missing from the table 6.5 is the DAX (The DAX futures market).
This is because the DAX has a tick value of EUR 12.50, so it is one of the highest tick value markets.
Therefore, it is not suitable for beginning day traders.

Future Price Quotations

Future price quotations can be explained as that price which has been stated or offered by the buyer to
the seller of the futures contracts. In most of the developed countries, future price quotations can be
reached by the following two methods.

1. Cost of Carry Model

2. Expectancy Model

Let us discuss each model of futures pricing in detail.

Cost of Carry Model of Futures Pricing

Equation 2 represents the formula to calculate the fair price of the commodity.

Fair Pr ice = Spot Pr ice + Cost of Carry − Inflows ........ Eq. 2

where, Cost of carry is the financing cost, storage cost and insurance cost

Equation 2 can also be represented symbolically as shown in equation 3.

FPtT = CP t + CPt ∗ (R tT − D tT ) ∗ (T − t ) / 365 ........ Eq. 3


 FPtT = Fair price of the asset at time t for the period up to time T
 CPt= Cash price of the asset
 RtT = Interest rate at time t for the period up to T
 DtT = Inflows in terms of dividend or interest between t and T

If ‘Futures price’ is greater than the ‘Fair price’, it is better to buy in the cash market and
simultaneously sell in the futures market.

If ‘Futures price’ is less than the ‘Fair price’, then it is better to sell in the cash market and
simultaneously buy in the futures market.
This arbitrage between cash and future markets will remain till prices in the cash and future
markets get aligned.

Assumptions of Cost of Carry Model

The following are the set of assumptions of cost of carry model.

 No seasonal demand and supply in the underlying asset

 Storability of the underlying asset is not a problem
 The underlying asset can be sold short
 No transaction cost; no taxes
 No margin requirements, and so the analysis relates to a forward contract, rather than a
futures contract

Index Futures and Cost of Carry Model

In the normal market, relationship between cash and future indices is described by the cost and carry
model of futures pricing.

Expectancy Model of Futures Pricing

Expectancy model says that many-a-time it is not the relationship between the fair price and future
price but the expected spot price and future price which leads the market. This happens mainly when
underlying asset or instrument is not storable or may not be sold short, for instance, in the
commodities market.

• E(S) can be above or below the current spot prices. This reflects market’s expectations. Figure 2
displays the relationship between expected spot price and Future price.

Figure 2. Relationship between Expected Spot Price and Future Price


• S = Spot prices
• F = Future prices
• E(S) = Expected spot prices

Contango market: Market when future prices are above cash prices
Backwardation market: Market when future prices are below cash prices

In India, the way of pricing any Future is to factor in the current price and holding costs or cost of
carry. As we already know, the futures contract is usually for a specified period of time, at the end of
which, it is settled. The buyer has to pay some interest in order to compensate the seller for waiting till
expiry for realising the sale proceeds which is reflected in the form of cost of carry.

In general the futures prices are calculated by the formula represented in equation 4.

Futures Pr ice = Spot Pr ice + Cost of Carry ........ Eq. 4

In equation 4, the cost of carry is the sum total of all the costs incurred in case a similar position is
taken in cash market and carried to maturity of the futures contract minus any revenue which may
result in this period. The costs typically include interest in case of financial futures (also insurance and
storage costs in case of commodity futures). The revenue may comprise of dividends in case of index

Apart from the theoretical value as calculated using the formula represented by equation 6.4, the
actual value of the future price may vary depending on demand and supply of the underlying at
present and expectations about the future. These factors play a much more important role in
commodities, especially perishable commodities than in financial futures.
Usually, in case of a bullish sentiment in the market, the futures price is greater than the spot price. On
account of a bearish view in the market which makes it a special case, when cost of carry is negative,
the futures price may be lower than spot prices.

Trading Mechanism of Futures

For future markets, one must understand that they work on the principle of convergence of future
prices to the spot prices at the time of delivery.

Suppose the future prices go above or below to expected spot prices then obviously traders would
have a clear arbitrage opportunity and would exploit it either by going short or long. Keynes and
Hicks have argued that in case hedger tends to shorten his position and speculator tends to lengthen
his position then future price will fall below the expected future spot price. This is because the
speculator would require compensation for the risk he is bearing.

Hence, one can trade only if there is an expectation that the future price will rise again. Converse will
happen in case hedger tends to lengthen his position and speculator tends to shorten his position. The
mechanism of futures contracts can be understood by going through the following explanation:

• Buy a future to agree to take delivery of a commodity. This will protect against a rise in
price in the spot market as it produces a gain if spot prices rise. Buying a future is said to be
going long.
• Sell a future to agree to make delivery of a commodity. This will protect against a fall in
price in the spot market as it produces a gain if spot prices fall. Selling a future is said to be
going short.

Futures Contract

A futures contract is a contract for delivery of a standard package of a standard commodity or

financial instrument at a specific date and place in the future but at a price that is agreed when the
contract is taken out

Certain futures contracts, such as on stocks or currency, settled in cash on the price differentials,
because clearly, delivery of this particular commodity would be difficult.

As already discussed, the futures price is the sum of spot price and costs of carrying, where spot price
is the current price of a commodity and the costs of carrying of a commodity is the aggregate of the

(a) Storage
(b) Insurance
(c) Transport costs involved in delivery of commodity at an agreed place
(d) Finance costs, that is, interest forgone on funds used for purchase of the commodity

Although the spot price and futures price generally move in line with each other, the basis is not
constant. Equation 5 represents the formula to calculate basis.

Basis = Futures Pr ice −Spot Pr ice ........ Eq. 5

Generally, the basis will decrease with time. And on expiry, the basis is zero and futures price equals
spot price.
If the futures price is greater than the spot price, it is called contango. Under normal market conditions
futures contracts are priced above the spot price. This is known as the contango market. In this case,
the futures price tends to fall over time towards the spot, equalling the spot price on delivery day.

If the spot price is greater than the futures price it is called ‘backwardation’. Then the futures price
tends to rise over time to equal the spot price on the delivery day. So in either case, the basis is zero at
delivery. This may happen when the cost of carry is negative, or when the underlying asset is in short
supply in the cash market, but there is an expectation of increased supply in future, for example
agricultural products.

The direction of the change in price tends to hold for cycles of contracts with different delivery dates.
If the spot price is expected to be stable over the life of the contract, a contract with a positive basis
will lead to a continued positive basis although this will be lower in nearby delivery dates than in far-
off delivery dates. This is a normal contango.

Conversely, normal backwardation is the result of a negative basis where nearer maturing contracts
has higher futures prices than far-off maturing contract.

Figure 3 illustrates the concepts of contango and backwardation in case of Futures contracts.





Delivery Time Time

Figure 3. Futures Contracts – Contago and Backwardation

Simple Pay-off Positions in Futures

The buyer of a futures contract is said to ‘go long’ the future, whereas the seller is said to ‘go short.’
With a long position, the value of the position rises as the asset price rises and falls as the asset price
falls. With a short position, a loss ensues if the asset price rises but profits are generated if the asset
price falls.

Buyer’s Pay-off
The buyer of futures contract has an obligation to purchase the underlying instrument at a price when
the spot price is above the contract price. The buyer will buy the instrument for the price ‘C’ and can
sell the instrument for higher spot price thus making a profit. When the contract price is above spot
price, a loss is made by the buyer of the contract.
Seller’s Pay-off
The seller of the contract makes a profit when the contract price is above the spot price. The seller will
purchase the instrument at the spot price and will sell at the contract price. The seller makes a loss
when the spot price is above the contract price.

Figure 4 represents the Pay-off in Long and Short Futures Position.

P ro fit L o n g p o s i t io n S h o r t p o s it i o n

P ro fit
P a y o f f
0 0
F u t u r e p r ic e



P a y o f f
C = C o n t r a c t p r i c e C = C o n t r a c t p r i c e

Figure 4. Pay-off in Long and Short Futures Position

Suppose a trader has bagged an order for which he has to supply 2,000 tonnes of aluminium sheet
to the buyer within next two months.

After obtaining the order, the trader is observing a rise of price of aluminium sheet in the open
market. If such a rise continues, the profit margin of the trader may get shrunk; he may even land
on a huge loss just because of rise in the procurement price of the aluminium sheet.

But if the trader under the circumstances purchases aluminium sheet futures, then any loss for the
rise of price of aluminium to be bought by the trader for the supply order could be then off-set
against profit on the future contract.

However, if there is a fall of price, extra profit on fall of price of aluminium sheet can also be offset
against cost or loss of futures contract. So hedging technique is the equivalent of insurance facility
against market risk where price is always volatile.

Marking to Market

In futures contracts, a small payment known as ‘initial margin’ is required to be deposited with the
organised futures exchange. Due to fluctuations in the price of underlying asset, the balance in the
margin account may fall below specified minimum level or even become negative at the end of each
trading session.

All outstanding contracts are appraised at the settlement price of that session, which is called ‘marking
to market.’ This means adjusting the margin accounts of both the parties. A member incurring cost
should make payment of profit to the counter party and the value of future contracts is set to zero at
the end of each trading session. The daily settlement payments are known as ‘variation margin’
Closing Out of Futures Contract

A long position in futures can be closed out by selling futures while a short position in futures can be
closed out by buying futures on the exchange. Once position is closed out, only the net difference
needs to be settled in cash, without any delivery of underlying. Most contracts are not held to expiry
but closed out before that. If held until expiry, some are settled for cash and others for physical

Simple Strategies in Futures Market

Table 6 displays the simple strategies that are popular in the futures market.

Table.6. Popular Strategies in Futures Market

Strategy Explanation
• Buy a Future to agree to take delivery of a commodity to protect
against a rise in price in the spot market as it produces a gain if
Commodities spot prices rise. Buying a Future is said to be going long
Futures Market
• Sell a Future to agree to make delivery of a commodity to
protect against a fall in price in the spot market as it produces a
gain if spot prices fall. Selling a Future is said to be going short
• Selling short an interest rate futures contract protects against a
rise in interest rates

Interest Rate • Purchasing long an interest rate futures contract protects against
Future a fall in interest rates. Future Rate Agreements (FRAs)

• Selling short on FRA protects against a fall in interest rates

• Purchasing long on FRA Protects against a rise in interest rates

• Buying long a currency Future protects against a rise in

Currency currency value
• Selling short a currency Future protects against a fall in
currency value

Clearing and Settlement of Futures

Clearing and settlement of futures is done by the clearing houses. Clearing houses serve as the agency
or a separate corporation of a futures exchange. These clearing houses are responsible for settling
trading accounts, clearing trades, collecting and maintaining margin monies, regulating delivery and
reporting trading data. They act as third parties to all futures contracts and play the role of a buyer to
every clearing member seller and a seller to every clearing member buyer.
Each futures exchange has its own clearing house. It is mandatory for all members of an exchange to
clear their trades through the clearing house at the end of each trading session.

It is also mandatory to deposit with the clearing house a sum of money sufficient to cover the
member's debit balance. This sum is based on clearing house margin requirements.

Suppose a member broker reports to the clearing house at the end of a trading day that he had a
total purchase of 100,000 tonnes of steel and total sales of 50,000 tonnes of steel, implying that he
would be net long 50,000 tonnes of steel.

Assuming that it is the broker's only position in futures and that the clearing house margin is 6
paisa/ton. Then, the broker would be required to have Rs. 3,000 on deposit with the clearing house.

Settlement may be of two types, namely, cash settlement and physical settlement.

Let us assume that the price of gold is Rs. 6000 on the date of expiration. So if the contract says
that you have to give someone a tula (1 tula = 100 gms) at Rs.5500, you lose Rs. 500. In case, both
you and your trading partner decide to settle this contract forever on the ground that he pays you
Rs. 500, it will be known as cash settlement.

National Securities Clearing Corporation Limited (NSCCL) was established in August 1995, which is
the first clearing corporation in India. It is a wholly owned subsidiary of NSE and acts as the body
responsible for carrying out the entire clearing and settlement process.

The primary functions of NSCCL are:

• To operate tight risk containment system

• To carry out the Novation (It is a process of replacement of one obligation by another
by mutual agreement of both the parties)
• To act as the counter party to all the trades
• To guarantee the final settlement

Model of Clearing and Settlement Process

Clearing members and clearing banks are the entities that help NSCCL in carrying out the activities of
clearing and settlement.

There are two types of clearing members. They are:

• Trading and Clearing Members (TCM): TCM clear and settle their own trades as well
as the trades of other trading members (TM)
• Professional Clearing Members (PCM): PCM clear the trades executed by trading
TCM and PCM have to pay deposit to undertake clearing and settlement of trades of every TM. TCM
and PCM have to open a separate bank account with NSCCL designated bank for settlement of trades.

Figure 5 represents the three components of the model of clearing and settlement process.

Figure 5. Model of Clearing and Settlement Process.

Clearing Mechanism:
The clearing mechanism involves the following steps.

• NSCCL works out open positions and obligations of clearing members (TCM and
PCM) at the end of every business day.
• Daily exposure limits and margin obligations are derived based on net open positions.
Net open contracts (Buy – Sell) multiplied by 1000 gives the net open positions in USD

Settlement Mechanism:
The settlement mechanism involves the following steps.

1. Settlement is done in cash mode payable in Indian Rupees (INR).

2. Daily Marking to Market (MTM) settlement takes place based on Daily Settlement
Price (DSP).
3. NSE daily disseminates DSP on its website.
4. If a client has carried forward the position from previous day, then MTM is calculated
as the difference between previous day’s DSP and current day’s DSP.
5. Clearing members with net loss in daily MTM have to pay the amount in cash. Clearing
members with net profit will receive the amount in cash. Payment and receipts are to be
settled on the basis of T+1 day.
6. Clearing members are responsible for collection/payment of daily MTM from/to the
trading members, who in turn are responsible for the client’s liabilities.
7. At the end of the day, all the net positions are carried forward to next day after resetting
with respect to the current day’s DSP.
8. Final settlement is also done in cash mode in terms of INR.
9. Final settlement price is the RBI reference rate on the last trading day of the expiry
10. Final profit and loss or MTM of all the net open positions of the clearing members will
be on the basis of final settlement price. Final settlement takes place on the basis of T+2

Risk Management
National Securities Clearing Corporation Limited (NSCCL) has a comprehensive risk management
system, which is constantly upgraded to pre-empt market failures. The Purpose is to make the trading
member obligations commensurate with their networth.

The following tasks are performed in the risk management process.

• Additional areas of perceived risk are identified
• Members are required to stick to capital adequacy requirements
• Unusually high pay-in liability members are required to make advance pay-in of funds
• Continuous monitoring of member performance and track record
• Intensive monitoring of members' position having concentration in certain high-risk
securities that attract high volumes and volatility is done
• Margin requirements are quite stringent
• Online monitoring of member positions
• An automatic disablement from trading is done when limits are breached
Motives for using Futures
Figure 6 displays the three motives for using futures contracting.


for using Price Discovery


Figure 6. Motives for using Futures

1. Hedging:
The classic hedging application would be that of wheat farmer forward/futures selling his
harvest at a known price in order to eliminate price risk. Conversely, a bread factory may want
to buy wheat forward/futures in order to assist production planning without the risk of price

2. Price Discovery:
Price discovery is the use of forward/futures prices to predict spot price that will prevail in the
future. These predictions are useful for production decisions involving the various
3. Speculation:
If a speculator has information or analysis which forecasts an upturn in a price, then he can go
long on the forward/futures market instead of the cash market, wait for the price rise, and then
take a reversing transaction. The use of forward/futures market here gives leverage to the

On the basis of the above motives, there exist various types of participants in futures market.

Figure 7 represents the major players in the futures markets.

Figure 7. Major Participants in the Futures Markets

Hedging Strategies using Futures

It may appear that companies in which individual investors place money do not have exposures to
financial prices. The predictability of future results shows a strong correlation with the volatility of
each strategy.

Future performance of strategies with high volatility is far less predictable than future performance
from strategies experiencing low or moderate volatility.

The following are the various hedging strategies using futures.

1. Aggressive Growth:
Under the aggressive growth strategy, hedge fund investors invest in equities expected to
experience acceleration in growth of earnings per share. These are generally high P/E
ratios, low or no dividends; often smaller and micro cap stocks, which are expected to
experience rapid growth.

The stocks that need aggressive growth strategy include sector specialist funds such as
technology, banking, or biotechnology. The strategy comprises of hedges by shorting
equities where earnings disappointment is expected or by shorting stock indexes. This type
of strategy tends to be “long-biased.”

The expected volatility of aggressive growth hedging strategy is high.

2. Distressed Securities:
Under the strategy of distressed securities, the investors buy equity, debt, or trade claims at
deep discounts of companies in or facing bankruptcy or reorganisation. Hence, the
investors will be profited from the market’s lack of understanding about the true value of
the deeply discounted securities. This is also because the majority of institutional investors
cannot own below investment grade securities.

This selling pressure creates the deep discount. The results of the strategy generally do not
depend on the direction of the markets.

The expected volatility of distressed securities type of hedging strategy is low to moderate.

3. Emerging Markets:
The strategy of emerging markets make the hedge funders invest in equity or debt of
emerging (less mature) markets, which tend to have higher inflation and volatile growth.

Short selling is not permitted in many emerging markets, and, therefore, effective hedging
is often not available, although bad debt can be partially hedged through Indian Treasury
futures and currency markets.

The expected volatility of emerging markets type of hedging strategy is very high.

4. Fund of Funds:
Fund of funds is a strategy which mixes and matches hedge funds and other pooled
investment vehicles. This blending of different strategies and asset classes aims to provide
a more stable long-term investment return than any of the individual funds.

The mix of underlying strategies and funds can control returns, risk and volatility. Capital
preservation is generally an important consideration. Volatility depends on the mix and
ratio of strategies employed.

The expected volatility of fund of funds type of hedging strategy is low to moderate.

5. Income:
The strategy based on income will have the primary focus on yield or current income rather
than solely on capital gains. Under this strategy, the investors may utilise leverage to buy
bonds and sometimes fixed income derivatives in order to profit from principal
appreciation and interest income.

The expected volatility of hedging strategy based on income is low.

6. Macro:
The macro strategy aims to profit from changes in global economies typically brought
about by shifts in government policy. The shifts in government policy impact interest rates,
in turn affecting currency, stock, and bond markets. Investor utilises hedging, but leveraged
directional bets tend to make the largest impact on performance.

The expected volatility of macro strategy is very high.

7. Market Neutral Arbitrage:

The market neutral arbitrage strategy attempts to hedge out most market risk by taking
offsetting positions, often in different securities of the same issuer.

Investors may also use futures to hedge out interest rate risk. It focuses on obtaining returns
with low or no correlation to both the equity and bond markets. These relative value
strategies include fixed income arbitrage, mortgage backed securities, capital structure
arbitrage, and closed-end fund arbitrage.

The expected volatility of the market neutral arbitrage strategy is low.

8. Market Neutral – Securities Hedging:

The strategist under this category invests equally in long and short equity portfolios
generally in the same sectors of the market. Market risk is greatly reduced, but effective
stock analysis and stock picking is essential to obtain meaningful results. Leverage may be
used to enhance returns.

The strategy has usually low or no correlation to the market. Sometimes market index
futures are used to hedge out systematic (market) risk. Relative benchmark indexes, usually
T-bills, are used in market neutral securities hedging.

The expected volatility of the market neutral securities hedging strategy is low.
9. Market Timing:
The market timing strategy allocates assets among different asset classes depending on the
manager’s view of the economic or market outlook. Portfolio emphasis may swing widely
between asset classes.

Unpredictability of market movements and the difficulty of timing entry and exit from
markets add to the volatility of this strategy.

The expected volatility of the market timing strategy is high.

10. Opportunistic:
Investment theme changes from strategy to strategy as opportunities arise to profit from
events such as Initial Public Offerings (IPOs), sudden price changes often caused by an
interim earnings disappointment, hostile bids, and other event-driven opportunities.

Investors may utilise several of these investing styles at a given time and is not restricted to
any particular investment approach or asset class.

The expected volatility of the opportunistic type of hedging strategy is variable.

11. Multi-Strategy:
Investment approach is diversified by employing various strategies simultaneously to
realise short and long-term gains. Other strategies may include systems trading such as
trend following and various diversified technical strategies.

Multi-strategy style of investing allows the manager to overweight or underweight different

strategies to best capitalise on current investment opportunities.

The expected volatility of the multi-strategy is variable.

12. Short Selling:

The strategy includes selling securities short in anticipation of being able to re-buy them at
a future date at a lower price. This is due to the manager’s assessment of the overvaluation
of the securities, or the market, or in anticipation of earnings disappointments often due to
accounting irregularities, new competition, change of management, and so on.
Often the short selling type of strategy is used as a hedge to offset long-only portfolios.
This strategy is also used by those who feel the market is approaching a bearish cycle.

The expected volatility of short selling strategy is very high.

13. Special Situations:

There are certain special situations in which the hedge funder invests in event-driven
situations such as mergers, hostile takeovers, reorganisations, or leveraged buy-outs.
Investors may simultaneously purchase stocks in companies being acquired, and sell stocks
in its acquirer, hoping to profit from the spread between the current market price and the
ultimate purchase price of the company. Investors may also utilise derivatives to leverage
returns and to hedge out interest rate and/or market risk. Results in such cases generally are
not dependent on direction of market.

The expected volatility of event-driven hedging strategy is moderate.

14. Value:
The value based strategies make the hedge funders invest in securities perceived to be
selling at deep discounts to their intrinsic or potential worth. Such securities may be out of
favour or underfollowed by analysts.

Long-term holding, patience, and strong discipline are often required until the market
recognises the ultimate value of the hedge funds.

The expected volatility of value based strategy is low to moderate.

Hedging Process

Hedging is a two-step process. A gain or loss in the cash position due to changes in price levels will
be countered by changes in the value of a futures position. In this type of transaction, the hedger tries
to fix the price at a certain level with the objective of ensuring certainty in the cost of production or
revenue of sale.

The futures market also has substantial participation by speculators who take positions based on the
price movement and bet upon it. Also, there are arbitrageurs who use this market to pocket profits
whenever there are inefficiencies in the prices. However, they ensure that the prices of spot and
futures remain correlated.

Let us discuss the hedging process with an example ‘Case of Cloth’.

Case of Cloth

A garment manufacturer purchases huge quantities of cloth as raw material for garment production.
The garment manufacturer enters into a contractual agreement to export garments three months
afterwards to dealers in the European market. This presupposes that the contractual obligation has
been fixed at the time of signing the contractual agreement for exports.

The garment manufacturer is now exposed to risk in the form of increasing cloth prices. In order to
hedge against price risk, the garment manufacturer can buy cloth futures contracts, which would
mature in three months. Hence, in case of increasing or decreasing cloth prices, the garment
manufacturer is protected.

Let us analyse the different scenarios such as the case of increasing or decreasing cloth prices.

Increasing Cloth Prices

If the cloth prices increase, this would result in increase in the value of the futures contracts, which
the garment manufacturer has bought. Hence, he makes profit in the futures transaction. But the
garment manufacturer needs to buy cloth in the physical market to meet his export obligation. This
means that he faces a corresponding loss in the physical market. But this loss is offset by his gains
in the futures market.

Finally, at the time of purchasing cloth in the physical market, the garment manufacturer can square
off his position in the futures market by selling the cloth futures contract, for which he has an open

Decreasing Cloth Prices

If cloth prices decrease, this would result in a decrease in the value of the futures contracts, which
the garment manufacturer has bought. Thus, he makes losses in the futures transaction. But the
garment manufacturer needs to buy cloth in the physical market to meet his export obligation. This
means that he faces a corresponding gain in the physical market. The loss in the futures market is
offset by his gains in the physical market.

Finally, at the time of purchasing cloth in the physical market, the garment manufacturer can square
off his position in the futures market by selling the cloth futures contract, for which he has an open

This results in a perfect hedge to lock the profits and protect from increase or decrease in raw
material prices. It also provides the added advantage of just-in time inventory management for the
garment manufacturer.

Buying Hedge or Long Hedge

A buying hedge is also known as a long hedge, means buying a futures contract to hedge a cash
position. Dealers, consumers, fabricators, and others, who have taken or who intend to take an
exposure in the physical market and want to lock-in prices, use the buying hedge strategy.

The benefits of buying hedge strategy are that:

• It replaces inventory at a lower prevailing cost

• It protects uncovered forward sale of finished products

The purpose of entering into a buying hedge is to protect the buyer against price increase of a
commodity in the spot market that has already been sold at a specific price but not purchased as yet. It
is very common among exporters and importers to sell commodities at an agreed-upon price for
forward delivery. If the commodity is not yet in possession, the forward delivery is considered

Long hedgers are traders who have made formal commitments to deliver a specified quantity of raw
material or processed goods at a later date, at a price currently agreed upon and who do not have the
stocks of the raw material necessary to fulfill their forward commitment.
Selling Hedge or Short Hedge

A selling hedge is also known as a short hedge, means selling a futures contract to hedge.

The following are the benefits of selling hedge strategy.

• It covers the price of finished products

• It protects inventory not covered by forward sales
• It covers the prices of estimated production of finished products

Short hedgers are traders who acquire inventories of the commodity in the spot market and who
simultaneously sell an equivalent amount or less in the futures market. The hedgers in this case are
said to be long in their spot transactions and short in the futures transactions.
The Basis
In the business of buying or selling a commodity, the spot price is different from the price quoted in
the futures market. The futures price is the spot price adjusted for costs such as freight, handling,
storage and quality, along with the impact of supply and demand factors. The price difference
between the spot and futures keeps on changing regularly.
The price difference between spot price and futures price is known as the basis. The risk arising
out of the difference is defined as basis risk.
A situation in which the difference between spot and futures prices reduces (either negative or
positive) is known as narrowing of the basis.
If the difference between spot and futures prices increases (either on negative or positive side) it
is defined as widening of the basis.
In a market characterised by the situation when:

• Hedger is benefited as follows when the futures price is higher than spot price.

 A narrowing of the basis will benefit the short hedger

 A widening of the basis will benefit the long hedger

• Hedger is benefited as follows when the futures quote at a discount to spot price.

 A narrowing of the basis will benefit the long hedger

 A widening of the basis will benefit the short hedger

However, the impact of widening of the basis is opposite to that as in the case of narrowing.

Futures Markets in India

Organised futures market evolved in India by the setting up of "Bombay Cotton Trade Association
Ltd." in 1875. In 1893, following widespread discontent amongst leading cotton mill owners and
merchants over the functioning of the Bombay Cotton Trade Association, a separate association by
the name "Bombay Cotton Exchange Ltd." was constituted.

The futures trading in oilseeds was organised in India for the first time with the setting up of Gujarati
Vyapari Mandali in 1900, which carried on futures trading in groundnut, castor seed and cotton.
Before the Second World War broke out in 1939, several futures markets in oilseeds were functioning
in Gujarat and Punjab.
Futures trading in raw jute and jute goods began in Calcutta with the establishment of the Calcutta
Hessian Exchange Ltd., in 1919. Later East Indian Jute Association Ltd. was set up in 1927 for
organising futures trading in Raw Jute. These two associations amalgamated in 1945 to form the
present East India Jute & Hessian Ltd., to conduct organised trading in both raw jute and jute goods.

In case of wheat, futures markets were in existence at several centers at Punjab and Uttar Pradesh
(UP). The most notable amongst them was the Chamber of Commerce at Hapur, which was
established in 1913. Other markets were located at Amritsar, Moga, Ludhiana, Jalandhar, Fazilka,
Dhuri, Barnala and Bhatinda in Punjab and Muzaffarnagar, Chandausi, Meerut, Saharanpur, Hathras,
Gaziabad, Sikenderabad and Barielly in U.P.

Futures market in bullion began at Mumbai in 1920 and later similar markets came up at Rajkot,
Jaipur, Jamnagar, Kanpur, Delhi and Kolkata. In due course several other exchanges were also created
in the country to trade in such diverse commodities as pepper, turmeric, potato, sugar and gur

Commodity Futures Market in India

After independence, the Constitution of India brought the subject of "Stock Exchanges and Futures
Markets" in the Union list. As a result, the responsibility for regulation of commodity futures markets
devolved on Government of India (GoI).

A Bill on forward contracts was referred to an expert committee headed by Professor A.D. Shroff and
Select Committees of two successive Parliaments. Finally, in December 1952 Forward Contracts
(Regulation) Act, 1952, was enacted.

The Forward Contracts (Regulation) Act provided for 3-tier regulatory system, that is:

• An association recognised by the GoI on the recommendation of Forward Markets

• The Forward Markets Commission was set up in September 1953. Forward Contracts
• Central Government

The rules of Forward Contracts (Regulation) Act were notified by the Central Government in July,

The Forward Contracts (Regulation) Act divides the commodities into 3 categories with reference to
extent of regulation, namely:

i. The commodities in which futures trading can be organised under the auspices of recognised
ii. The commodities in which futures trading is prohibited
iii. The commodities which have neither been regulated for being traded under the recognised association
nor prohibited are referred as Free Commodities. The association organised in such trading of free
commodities is required to obtain the Certificate of Registration from the Forward Markets Commission.

In the seventies, most of the registered associations became inactive, as futures as well as forward
trading in the commodities for which they were registered came to be either suspended or prohibited
The Khusro Committee (June 1980) had recommended reintroduction of futures trading in most of the
major commodities, including cotton, kapas, raw jute and jute goods and suggested that steps may be
taken for introducing futures trading in commodities, such as, potatoes, onions, and so on, at
appropriate time.

The government, accordingly initiated futures trading in potato during the latter half of 1980 in quite a
few markets in Punjab and Uttar Pradesh. After the introduction of economic reforms since June 1991
and the consequent gradual trade and industry liberalisation in both the domestic and external sectors,
the GOI appointed in June 1993 one more committee on Forward Markets under Chairmanship of
Professor K.N. Kabra.

The committee on Forward Markets under Chairmanship of Professor K.N. Kabra submitted its report
in September 1994.
The majority report of the Committee recommended that futures trading be introduced in the
following commodities.

1. Basmati Rice
2. Cotton and Kapas
3. Raw Jute and Jute Goods
4. Groundnut, Rapeseed/Mustard Seed, Cotton Seed, Sesame Seed, Sunflower Seed, Safflower Seed,
Copra And Soybean, and oils and oilcakes of all of them
5. Rice Bran Oil
6. Castor Oil and its Oilcake
7. Linseed
8. Silver
9. Onions

The committee also recommended that some of the existing commodity exchanges particularly the
ones in pepper and castor seed, may be upgraded to the level of international futures markets.

The liberalised policy being followed by the GOI and the gradual withdrawal of the procurement and
distribution channel necessitated setting in place a market mechanism to perform the economic
functions of price discovery and risk management.

The National Agriculture Policy announced in July 2000 and the announcements of Honourable
Finance Minister in the Budget Speech for 2002-2003 were indicative of the Governments resolve to
put in place a mechanism of futures trade/market.

As a follow up, the Government issued notifications on April 1st, 2003 permitting futures trading in
the commodities, with the issue of these notifications futures trading is not prohibited in any

At present, the concept of futures trading is permitted in 103 commodities. Apart from the three
national level exchanges, there are 21 other regional exchanges recognised for commodity futures
trading. The trading volume and value in the past two years have increased manifold.

In India, futures trading proved itself to be extremely beneficial in performing two important
functions of price discovery and price risk management with reference to the given commodity. This
in turn proved to be beneficial to all segments of the economy.
To the producer it was useful because he can now get an idea of the price likely to prevail at a future
point of time and therefore can decide between various competing commodities, the best that suits
him. It enables the consumer in that he gets an idea of the price at which the commodity would be
available at a future point of time. The producer can do proper costing and also cover his purchases by
making forward contracts.

The concept of futures trading is very useful to the exporters. Because, futures trading concept
provides an advance indication of the price likely to prevail. Thus, helps the exporter in quoting a
realistic price and thereby secure export contract in a competitive market. Having entered into an
export contract, it enables him to hedge his risk by operating in futures market.

Since, the concept of futures trading involves a passage of time between entering into a contract and
its performance making, the contracts are susceptible to risks, uncertainties, and so on. Therefore, the
there was an immense need of the regulatory functions that are to be exercised on the futures market.

Unfortunately till 2008, Forward Markets Commission (FMC) did not have regulatory powers and
authority like Securities and Exchange Board of India (SEBI). It also did not have the financial
autonomy as it depended on budgetary allocation and its administrative autonomy was also restricted
as it was subject to rules and regulations of the Government in all matters including recruitment of

But with the promulgation of the Forward Contracts (Regulation) Amendment Ordinance, 2008, the
role of FMC changed from enforcing prohibition to properly managing and regulating such explosive

Forward Markets Commission has so far managed to discharge this role through the instruments of
margin, limit on open interest, price limits and others. However, a need is felt to further strengthen
and enhance the capabilities of FMC as well as to give it the necessary autonomy by making
comprehensive amendments to the FCR Act.

During 2007-08 (till January, 2008), the volumes traded on the commodity exchanges have been
Rs. 31.60 lakh crores. As per the estimates projected by Associated Chambers of Commerce and
Industry of India (ASSOCHAM), the trade value would increase to Rs. 74 lakh crores by 2010.

By April, 2009, the share of agriculture commodities including essential commodities in the total
commodity futures trade turnover was about 25%. The share of essential commodities in the overall
futures trading was about 8%.

The volume of trade in bullion (gold and silver) had about 38% share, energy products had a share of
12% and other metals and commodities, such as, alluminium, zinc, tin, copper, lead, sponge iron,
steel, polymer and so on, had a share of about of 25 % in the total turnover.

Currency Futures Market in India

In the year 2008 only, the Reserve Bank of India (RBI) issued a set of directions and guidelines for
the launch of currency futures trading in India.
The following are the main highlights of currency.

• Currency futures are permitted in US Dollar, Indian Rupee or any other currency pairs, as
may be approved by the Reserve Bank from time to time.
• Only ‘persons residing in India’ may purchase or sell currency futures to hedge an exposure
to foreign exchange rate risk or otherwise.

The following are the features of the standardised currency futures.

• Only USD-INR contracts are allowed to be traded

• The size of each contract will be USD 1000
• The contracts shall be quoted and settled in Indian Rupees
• The maturity of the contracts shall not exceed 12 months
• The settlement price will be the Reserve Bank’s Reference Rate on the last trading day

The following are the guidelines regarding the participants.

• No person other than 'a person residing in India' as defined in section 2(v) of the Foreign
Exchange Management Act, 1999 (Act 42 of 1999) will participate in the currency futures
• Notwithstanding sub-paragraph (i), no scheduled bank or such other agency falling under
the regulatory purview of the Reserve Bank under the Reserve Bank of India Act, 1934, the
Banking Regulation Act, 1949 or any other Act or instrument having the force of law will
participate in the currency futures market without the permission from the respective
regulatory Departments of the Reserve Bank.

Similarly, for participation by other regulated entities, concurrence from their respective
regulators should be obtained.

The following are regarding the membership of the currency futures.

• The membership of the currency futures market of a recognised stock exchange will be
separate from the membership of the equity derivative segment or the cash segment.

Membership for both trading and clearing, in the currency futures market will be subject to
the guidelines issued by the SEBI.

• Banks authorised by the Reserve Bank of India under section 10 of the Foreign Exchange
Management Act, 1999 as ‘AD Category-I bank’ are permitted to become Trading and
Clearing Members of the currency futures market of the recognised stock exchanges, on
their own account and on behalf of their clients. The respective banks are subject to
fulfilling the following minimum prudential requirements.

(a) Minimum net worth of Rs. 500 crores

(b) Minimum CRAR of 10 per cent
(c) Net NPA should not exceed 3 per cent
(d) Made net profit for last 3 years

The AD Category-I banks which fulfill the prudential requirements should lay down detailed
guidelines with the approval of their Boards for trading and clearing of currency futures contracts and
management of risks. AD Category-I banks which do not meet the above minimum prudential
AD Category-I banks which are Urban Co-operative banks or State Co-operative banks can participate
in the currency futures market only as clients, subject to approval therefore, from the respective
regulatory Departments of the Reserve Bank.

Position Limits:
The position limits for various classes of participants in the currency futures market will be subject to
the guidelines issued by the SEBI.

The AD Category-I banks, will operate within prudential limits, such as Net Open Position (NOP) and
Aggregate Gap (AG) limits. The exposure of the banks, on their own account, in the currency futures
market shall form part of their NOP and AG limits.

Risk Management Measures in Currency Future Markets

The trading of currency futures will be subject to maintaining initial, extreme loss and calendar spread
margins. The Clearing Corporations/Clearing Houses of the exchanges should ensure maintenance of
such margins by the participants on the basis of the guidelines issued by the SEBI from time to time.

Surveillance and Disclosures in Currency Futures Market

The surveillance and disclosures of transactions in the currency futures market shall be carried out in
accordance with the guidelines issued by the SEBI.

Authorisation to Currency Futures Exchanges/Clearing Corporations

Recognised stock exchanges and their respective Clearing Corporations/Clearing Houses shall not
deal in or otherwise undertake the business relating to currency futures unless they hold an
authorisation issued by the Reserve Bank under section 10 (1) of the Foreign Exchange Management
Act, 1999.

Powers of Reserve Bank

The Reserve Bank may from time to time modify the eligibility criteria for the participants, modify
participant-wise position limits, prescribe margins and/or impose specific margins for identified
participants, fix or modify any other prudential limits, or take such other actions as deemed necessary
in public interest, in the interest of financial stability and orderly development and maintenance of
foreign exchange market in India.

Robust trading volumes in currency derivatives have drawn nine public-sector banks led by:

• Bank of India
• Federal Bank
• Minerals and Metals Trading Corporation (MMTC)
• Jaypee Capital

Robust trading volumes in currency derivatives have drawn nine public-sector banks to jointly float
India’s fourth currency futures exchange the ‘United Stock Exchange of India Ltd’ (USEIL).

Other Stakeholders

With an authorised capital of Rs 150 crore and paid-up capital of Rs 120 crore, the new
exchange has received in-principle approval from the Securities and Exchange Board of India
(SEBI). It will commence operations in two months, said Mr. P.H. Ravikumar, Director,
Federal Bank.
Besides Bank of India, the other public-sector banks with stake in USEIL are Andhra Bank,
Allahabad Bank, Bank of Baroda, Canara Bank, Indian Overseas Bank, Oriental Bank of Commerce,
Union Bank of India and United Bank of India. The nine public-sector banks and MMTC together
will hold minimum 49 per cent stake in the exchange.

“The background of the promoters places the exchange in an ideal position to build liquidity
quickly. We will partner industry associations and reach out to the farthest geographies in the
country to enable the smallest enterprise which runs a currency risk to understand the
exchange platform mechanism and then use the same for mitigating risks,” said Mr T.S.
Narayanasami, Chairman and Managing Director, Bank of India.
USEIL expects to ride on the strength of the promoter-banks in different geographies to offer its
exchange-traded currency futures product to the latter’s customers.

“The promoters’ shareholding in USEIL will vary from 2.5 to 15 per cent. Bank of India,
Federal Bank, MMTC, and Jaypee will be the majority shareholders,” said Mr M.
Venugopalan, Managing Director and CEO, Federal Bank.

As per regulatory prescription, an entity cannot hold more than 5 per cent stake in a currency futures
exchange. However, SEBI allows time for dilution of the stake exceeding this threshold. Currently,
three entities offer trading in currency futures in dollar-rupee contracts. The three entities are NSE,

Source: 9 PSBs on board new currency futures exchange,

Interest Rate Futures Market in India

Ever since the global financial crisis hit the economies world over in the year 2008, more and more
regulators and markets across the world are drifting away from the over-the-counter forward market
to embrace exchange-traded market. The main reason for this change is that the experts waste the
centrally counter-party guaranteed exchange-traded market.

The exchange where the currency futures are traded is perhaps the one institution to have come out
unscathed in this economic meltdown. In India, the trading in the newly launched interest rate futures
began on August 31, 2009 clocking trading volumes of Rs. 276 crore in their first day of trade.

The underlying for interest rate futures trading is the Government of India's securitised 10-year
notional coupon bond. The qualification of GoI securities to be used as underlying assets is that it
should have a maturity status between seven-and-a-half years and 15 years from the first day of the
delivery month. Apart from this, the outstanding should be for a minimum value of Rs. 10,000 crore
(Rs 100 billion).

There will be a regular publishing of the list of deliverable-grade securities at the exchanges. To be
eligible to trade in interest rate futures market then, one has to be a company, or a bank, or a foreign
institutional investor, or a non-resident Indian or a retail investor.

Investors can trade live in interest rate futures on the currency derivatives segment
of the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE).
Contract size and quotation:
Globally, the interest rate futures are almost 25-30 per cent of all derivatives. In India the trading on
the NSE will see a minimum contract size of Rs. 200,000. As far as the quotation is concerned, it
would be the same as the quoted price of GoI securities and with a count convention of 30/360-day.

Maximum tenor of contracts:

While the maximum tenure of the futures contract is one year or 12 months. Usually, it will have to be
rolled over in three months making the contract cycle span over four fixed quarterly contracts.

Daily settlement calculation and procedure for final settlement:

Under normal circumstances, the weighted average price of the futures contract for the final 30
minutes would be taken as the daily settlement price. However, at times when this trading is not
carried out, the exchange would fix the theoretical price as the daily settlement rate.

Usually, the daily settlement is done on a daily marked-to-market procedural basis while the final
settlement would be through physical delivery of securities.

Index Futures Market in India

The National Stock Exchange (NSE) introduced stock index futures and options on the NSE’s index
of 50 stocks (S&P CNX NIFTY) in June 12, 2000. The index futures contracts are based on the
popular market benchmark S&P CNX Nifty index.
NSE defines the characteristics of the futures contract such as the underlying index, market lot, and
the maturity date of the contract.

The futures contracts are available for trading from introduction to the expiry date. Contracts have a
maximum of 3-month trading cycle; they are the near month (one), the next month (two) and the far
month (three). A new 3 month contract is introduced on the trading day following the expiry of the
near month contract. This way, at any point in time, there will be 3 contracts available for trading in
the market.

Index futures contracts expire on the last Thursday of the expiry month. If the last Thursday is a
trading holiday, then the contracts expire on the previous trading day.


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