A forward contract is a private agreement between two parties to buy or sell an asset at a future date for a price decided today. They are highly customizable and traded "Over-the-Counter" (OTC), meaning they are not traded on a formal exchange. Both parties are obligated to honor the deal.
🔑 Example: On May 11, you agree with a goldsmith to buy 10 gm of gold after 1 month at ₹62,337. If after 1 month, the spot price of gold is ₹62,700, you make a profit of ₹363. If the spot price is ₹62,100, you incur a loss of ₹237.
Forwards remove price uncertainty but carry significant risks:
Liquidity Risk: It's difficult to exit the contract before its maturity.
Counterparty/Default Risk: One party may fail to honor the contract, leading to a financial loss for the other.
Lack of Transparency: The terms are private and not publicly available.
3.2 Futures Contracts
Futures contracts are standardized forward contracts that are traded on organized exchanges. The clearing corporation of the exchange acts as a central counterparty, guaranteeing the settlement of all contracts. This eliminates counterparty risk, which is a major limitation of forward contracts.
Futures contracts have the following key features:
Standardized: The terms (lot size, expiry date, etc.) are fixed by the exchange.
Exchange-Traded: They are bought and sold on a public exchange.
Daily Settlement (Mark-to-Market): Profits and losses are settled daily, preventing large build-ups of risk.
👉 The key difference is that forwards are private and carry high counterparty risk, while futures are standardized, exchange-traded, and are guaranteed by the clearing corporation.
3.3 Futures Contract Specifications
Each futures contract has a set of standard specifications defined by the exchange. For example, for Nifty Futures on the NSE:
Underlying Asset: Nifty 50 Index
Contract Size: A fixed number of units, also known as the "lot size" (e.g., 25 units for Nifty).
Contract Value: This is calculated as: Futures Price x Lot size.
Expiry: The contract expires on a specific date (e.g., the last Thursday of the month).
Tick Size: The minimum price fluctuation for the contract (e.g., ₹0.05 for Nifty).
Settlement: Daily MTM and final settlement on the expiry date.
📌 SEBI Rule (2024): The minimum contract value for all derivatives is between ₹15–20 lakhs. Lot sizes will be adjusted to meet this requirement.
3.4 Key Terminology
Basis: The difference between the spot price and the futures price (Spot price - Futures price). If the futures price is higher than the spot price, it is called a "negative basis". At expiry, the basis converges to zero.
Cost of Carry: The interest paid on holding the underlying asset minus any dividend earned. It's a key factor in explaining why the futures price is not the same as the spot price.
Margins:
Initial Margin: The amount deposited when entering a contract.
Mark-to-Market (MTM): The daily settlement of profits and losses.
Open Interest (OI): The total number of outstanding or open contracts that have not yet been settled or closed. It indicates market depth.
Volume: The total number of contracts traded over a specific period.
Positions:
Long: Buying a futures contract to profit from a price increase.
Short: Selling a futures contract to profit from a price decrease.
Open Position: A contract that has not been squared off.
Naked Position: A futures position taken without holding the underlying asset.
Calendar Spread: A position where one buys a futures contract with one expiry and sells another with a different expiry.
3.5 Forwards vs Futures (Comparison)
Feature
Forwards
Futures
Trading
OTC (private deal)
Exchange-traded
Standardization
Customized
Standardized
Counterparty Risk
High
None (guaranteed by exchange)
Liquidity
Low
High
Price Discovery
Poor
Efficient (centralized market)
3.6 Payoff Charts for Futures
Futures contracts have linear payoffs, which means the potential for both profit and loss is unlimited. The payoff is directly proportional to the change in the underlying asset's price.
Example (Long Futures at ₹100):
If the underlying price moves to ₹150, the profit is ₹50.
If the underlying price moves to ₹70, the loss is ₹30.
The graph of a long futures position is a straight line sloping upwards, while a short futures position is a straight line sloping downwards.
✅ Key Takeaways
A Forward contract is a private, customized, and risky agreement.
A Futures contract is a standardized, exchange-traded, and safer version of a forward.
Futures contracts eliminate counterparty risk because their settlement is guaranteed by the clearing corporation.
Key terms to remember: Basis, Cost of Carry, Margins, MTM, Open Interest, Long/Short positions.
Futures payoffs are linear, meaning they have the potential for both unlimited profit and unlimited loss.