Chapter 3

Introduction to
Forwards & Futures

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Forward Contract

 Forward contract is an agreement made

directly between two parties to buy or sell an
asset on a specific date in the future, at the
terms decided today. Forwards are widely
used in commodities, foreign exchange,
equity and interest rate markets.

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Example
 Assume you wanted purchase gold today and
the market price is 60,000 for 10 gm, you
paid the money and bought the gold this is
cash market
 Now suppose you do not want to buy it today

but after 1 year.

 Goldsmith quotes a price of 62000/gms, you

agree and make the agreement and go away,

here you have bought a long futures and gold
smith is short futures

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Essential features

 It is a contract between two parties (Bilateral

contract).
 All terms of the contract like price, quantity

and quality of underlying, delivery terms like

place, settlement procedure etc. are fixed on
the day of entering into the contract.
 It is OTC transaction

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Major limitations of forwards
 Liquidity Risk

 Tailor made contracts - other market

participants may not be interested in these
contracts
 Forwards are not listed or traded on

exchanges
 Hence it is very difficult for parties to exit

from the forward contract before the

contract’s maturity

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Counterparty risk
 Risk of an economic loss from the failure of
counterparty to fulfill its contractual
obligation.
 Eg – A & B enter a contract
 A will purchase gold at 62000 from B after 1

year
 Gold price after 1 year is 58000, now A may

purchase from market at 58000 and not

honour the contract and vice verca

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Futures Contract
 Futures markets were innovated to overcome
the limitations of forwards
 Agreement made through an organized

exchange
 Standardized forward contracts
 Clearinghouse associated with the exchange

guarantees settlement of these trades.

 Margins are payable by both the parties

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 Spot Price – Current price in cash market
 Futures price – Closing price of the

underlying asset
 Contract Cycle – Maximum term of the

contract on exchange is 3 months, The 1st

months is called near month, 2nd is next
month and 3rd is called Far month
 Expiry - Every futures contract expires on last

Thursday of respective month or the day

before if the last Thursday is a trading
holiday. On expiry date, all the contracts are
compulsorily settled.

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 Tick Size - Minimum move allowed in the
price quotations, Tick size for Nifty futures is
5 paisa.
 Contract Size - Futures contracts are traded

in lots and to arrive at the contract value we

have to multiply the price with contract
multiplier (Eg – Nifty fifty has multiply factor
of 50, Bank nifty has 15)
 Basis – Spot price – Futures price = Basis
 During the life of the contract, the basis may

become negative or positive, as there is a

movement in the futures price and spot price

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Cost of Carry
 Carrying cost is the interest paid to finance
the purchase (minus) dividend earned.
 For commodities - storage cost+ Interest

paid
 Eg – Reliance Cash market price – Rs 100
 Borrow money from bank at 10%
 Hold the share for 1 year
 Expected divided - Rs. 5
 Net Cost to carry = 10-5 = Rs 5

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 Margin Account – Account maintained with
brokers such as Demat account

 Initial Margin - The amount one needs to

deposit in the margin account at the time of
entering a futures contract is known as the
initial margin
 Assuming that the broker charges 10% of the

contract value as initial margin, the person

has to pay him Rs. 76,287 as initial margin

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Mark to Market

 Profits and losses are settled on day‐to‐day

basis

 The amount is debited from the loser party

and credited to the winning party on a daily
basis

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 Open Interest - total number of contracts
outstanding for an underlying asset.

 Price Band - Price Band is essentially the price

range within which a contract is permitted to
trade during a day

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Positions in Derivatives
 Long position
 Short Position
 Open position
 Naked and calendar spread positions
 Opening a position
 Closing a position

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Pay off Chart (Long)

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Pay off Chart (Short)

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Futures Pricing
 Cash and Carry Model for Futures Pricing
 (spot price + cost of carrying the asset from

today to the future date)

 Cost of carrying a financial asset from today

to the future date would entail different costs

like transaction cost, custodial charges,
financing cost, etc whereas for commodities,
it would also include costs like warehousing
cost, insurance cost, etc.

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 Eg :
 Spot price of Gold – 60,000/10gm
 Cost of financing – 5%
 Cost of Storage – 3%
 Cost of Insurance – 2%

 Future price after 1 yr – 60,000 +10% =

66,000
 Any difference in Future trading price can

cause arbitrage opportunity

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Cost of transaction and non‐
arbitrage bound
 Cost components of futures transaction like
margins, transaction costs (commissions),
taxes etc. create distortions and take markets
away from equilibrium.
 markets to be efficient, different costs of

operating in the markets should be as low as

possible

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Extension of cash & carry model to
the assets generating returns
 Modified formula of future fair price or
synthetic futures price is:
 Fair price = Spot price + Cost of carry ‐

Inflows
 In mathematical terms, F = S (1+r‐q)T
 r = Cost of carry, q = expected return
 If we use the continuous compounding, we

may rewrite the formula as: F= S*e(r‐q)*T

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 Spot price of Tata share = 100
 Cost of financing = 10%
 Expected return = 5%
 Period = 3 Months

 =100(10%-5%)^(90/365)
 =101.21

 Continuous Compounding
 S*e^(r-q)*t
 100*e^(10%-5%)*(90/365) = 101.24

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