Introduction to Forwards and Futures — NISM V-D

The heaviest-weighted chapter in Module 2 (15 marks). Forwards and futures are the linear building blocks of the derivatives market: they lock in a price today for a transaction in the future. This chapter formalises how a futures price relates to the spot price via cost-of-carry, how daily mark-to-market and margining protect the exchange, and how the futures price converges to spot at expiry. It closes with the three uses of futures — long/short hedging, speculation and cash-futures arbitrage.

Foundation

A forward is a customised OTC agreement to trade an underlying at a set price on a set future date; both parties are obliged and each bears the other's default risk. A futures contract is the exchange-traded, standardised version — fixed lot size and expiry, centrally cleared, and settled daily by mark-to-market (MTM) so gains and losses are realised each day rather than only at expiry. Payoffs are linear and symmetric: the buyer (long) profits rupee-for-rupee as the price rises and loses as it falls; the seller (short) is the mirror image. The "basis" is the difference between the futures price and the spot price; it can be positive or negative during the contract's life but must become zero at expiry, because at settlement the futures and spot prices must converge.

Deep Dive

The fair futures price is set by the Cost of Carry model (the no-arbitrage model). A synthetic futures position — buy the asset in the spot market today and carry it to the future date — must cost the same as buying the futures contract; if not, arbitrage closes the gap. So: Fair futures price = Spot price + cost of carrying the asset to delivery. For a financial asset the carry is mainly the financing cost (minus any income like dividends); for a commodity it also includes storage and insurance. Margining is what lets the exchange guarantee every trade. Initial margin is collected up front (sized by the contract's risk, via SPAN); mark-to-market margin settles the day's gains/losses so unrealised losses cannot accumulate unfunded. BOTH the buyer and the seller post margin — a common exam point, because unlike an option (where only the writer posts margin) a futures contract obliges both sides.

Worked example

Worked example — futures P&L and cost-of-carry (A) P&L on a short futures position (NISM workbook data) You sell one XYZ stock futures contract at ₹278; lot size 1,200. You later buy it back at ₹265. A short gains when the price falls. Profit = (Sell − Buy) × lot = (278 − 265) × 1,200 = 13 × 1,200 = ₹15,600 profit. (B) Reverse-engineering a short close You are short one June XYZ future (multiplier 50) at ₹3,400 and close with a ₹10,000 profit. Points gained = 10,000 / 50 = 200. A short profits by buying back lower, so you bought at 3,400 − 200 = ₹3,200. The closing action was "buy 1 June XYZ future at 3,200." (C) Cost-of-carry fair price (workbook bullion example) Spot gold ₹62,130 / 10g; three-month carry (financing + storage + insurance) ₹100 / 10g. Fair 3-month futures = 62,130 + 100 = ₹62,230 / 10g. If the traded future differs from this, an arbitrageur buys the cheap leg and sells the dear one until the gap closes.

Real-world scenario

Real-world scenario — a SIF manager's short hedge A Specialized Investment Fund holds a ₹40 crore large-cap book and expects a volatile budget week. The manager does not want to sell the stocks (tax, impact cost, and they still like the businesses) but wants to neutralise a week of market risk. She puts on a SHORT hedge: sell Nifty futures worth roughly ₹40 crore of exposure. If the market falls 4%, the stock book loses ~₹1.6 crore but the short futures gain ~₹1.6 crore, offsetting it. If the market rises, the gain on stocks is given up on the futures — that is the price of insurance. Note both legs required margin, and the hedge is only as good as the match between her book and the Nifty (basis risk). This is exactly the competence NISM V-D certifies before letting someone distribute a derivative-using fund.

Advanced

Two nuances the exam probes. First, calendar spreads: simultaneously long one expiry and short another of the same underlying. Because the two legs largely offset, a calendar spread attracts LOWER margin than the sum of two independent (naked) legs — the exchange recognises the reduced net risk. But when the near leg expires, the offset disappears and the farther leg becomes a regular open position carrying full margin — a candidate must know this transition. Second, hedging direction: a LONG hedge (buy futures) protects a planned future PURCHASE against a price rise; a SHORT hedge (sell futures) protects an existing holding or planned future SALE against a price fall. Getting the direction wrong doubles the exposure instead of cancelling it — the single most expensive mistake a hedger can make.

Regulatory references

SEBI framework for exchange-traded equity derivatives
Clearing corporation margining (initial / SPAN / mark-to-market / exposure)
Exchange contract specifications (lot size, expiry, settlement)

Common mistakes & pitfalls

Confusing long and short hedges — a long hedge protects a future purchase; a short hedge protects a holding or future sale.
Thinking only the seller posts margin — in futures BOTH buyer and seller post margin.
Assuming a calendar spread keeps its low margin forever — once the near leg expires, the far leg becomes a fully-margined open position.
Forgetting that basis must converge to zero at expiry — futures and spot prices meet at settlement.

Frequently asked

Why is the fair futures price higher than spot for most financial assets?

Because of carry. Holding the asset to the delivery date costs financing (and for commodities, storage/insurance). The futures price embeds that carrying cost: Fair futures = Spot + cost of carry (minus any income the asset pays).

Do both parties to a futures contract pay margin?

Yes. Unlike an option — where only the writer posts margin and the buyer just pays premium — a futures contract obliges both the buyer and the seller, so both post margin and are marked to market daily.

What is "basis" and where does it go at expiry?

Basis = futures price − spot price. It fluctuates during the contract's life but converges to zero at expiry, because final settlement forces the futures and spot prices to be equal.

Practice questions

Click each question to reveal the answer and explanation.

Q 1

You sold one XYZ Stock Futures contract at ₹278 and the lot size is 1,200. What is your profit (+) or loss (−) if you buy the contract back at ₹265?

(a)16,600
(b)15,600
(c)-15,600
(d)-16,600

Correct: (b) 15,600

A short profits when the price falls. Profit = (278 − 265) × 1,200 = 13 × 1,200 = ₹15,600 (a gain, so positive).

Q 2

You are short one June XYZ futures (contract multiplier 50) at ₹3,400. You close the position a few days later with a ₹10,000 profit (ignore brokerage). Which closing action produced this profit?

(a)Selling 1 June XYZ futures at 3,600
(b)Buying 1 June XYZ futures at 3,600
(c)Buying 1 June XYZ futures at 3,200
(d)Selling 1 June XYZ futures at 3,200

Correct: (c) Buying 1 June XYZ futures at 3,200

A short is closed by buying back. Profit of ₹10,000 ÷ 50 = 200 points, so you bought back 200 below your ₹3,400 entry = ₹3,200. "Buying 1 June XYZ future at 3,200" is the closing trade.

Q 3

A calendar spread contract in index futures attracts ____________.

(a)Same margin as the sum of two independent legs
(b)Lower margin than the sum of two independent legs
(c)Higher margin than the sum of two independent legs
(d)No margin at all

Correct: (b) Lower margin than the sum of two independent legs

The two legs of a calendar spread largely offset, so net risk is lower — the exchange charges LOWER margin than two independent naked legs. The "no margin" and "higher margin" options are the baits.

Q 4

Margins in futures trading are to be paid by ____________.

(a)Only the buyer
(b)Only the seller
(c)Both the buyer and the seller
(d)The clearing corporation

Correct: (c) Both the buyer and the seller

A futures contract obliges both sides, so BOTH the buyer and the seller post margin. (Contrast options, where only the writer posts margin.) The clearing corporation collects margin; it does not pay it.

Q 5

When the near leg of a calendar-spread transaction on index futures expires, the farther leg becomes a regular open position.

(a)True
(b)False

Correct: (a) True

True. Once the near leg settles, the offsetting benefit disappears and the remaining far leg is a normal open futures position — fully margined.

Educational purposes only. The numbers, returns, and examples used in this lesson are illustrative. Past performance does not guarantee future results. Mutual fund and securities investments are subject to market risks. This lesson is not investment advice; for advice tailored to your circumstances, consult a SEBI-registered Investment Adviser. Read our full disclaimer.