Chapter 3: Introduction to Forwards and Futures

LEARNING OBJECTIVES:
After studying this chapter, you should know about:
• Meaning of forward and futures contracts
• Terminology related to futures contracts
• Payoff for a futures contract
• Pricing of a futures contract
• Applications of a futures contract by speculators, hedgers and
arbitrageurs

3.1 Introduction to forward contracts

A 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.
Let us understand with the help of an example. What is the basic difference between cash
market and forwards? Assume that on May 11, 2024 you want to purchase gold from a
goldsmith. The market price for gold on this day is Rs. 62,130 for 10 grams of 24 carat gold
and the goldsmith agrees to sell you gold at this price. You pay him Rs. 62,130 for 10 grams
of gold and take delivery of the gold. This is a cash market transaction at a price (in this
case Rs. 62,130) referred to as spot price.
Now suppose you do not want delivery of the gold on May 11, 2024, but only after 1
month. The goldsmith quotes you Rs. 62,337 for 10 grams of gold. You agree to the
forward price for 10 grams of gold and go away. Here, in this example, you have “bought
a forward contract” or you are “long forward”, whereas the goldsmith has “sold a forward
contract” or he is “short forward”. There is no exchange of money or gold at this point of
time. After 1 month, you come back to the goldsmith pay him Rs. 62,337 and take 10
grams of gold from him. This is a forward, where both the parties are obliged to go
through with the contract irrespective of the value of the underlying asset (in this case
gold) at the time of delivery.
Essential features of a forward are:
• It is a contract between two parties (a 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.
In other words, forwards are bilateral over-the-counter (OTC) transactions where the
terms of the contract, such as price, quantity, quality, time and place are negotiated
between two parties to the contract. Any alteration in the terms of the contract is possible

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if both parties agree to it. Corporations, traders and investing institutions extensively use
OTC transactions to meet their specific requirements. The essential idea of entering into
a forward is to fix the price and thereby avoid the price risk. Thus, by entering into
forwards, one is assured of the price at which one can buy/sell an underlying asset.
In the above-mentioned example, if after one month the gold trades at Rs. 62,700 in the
cash market, the forward contract becomes favourable to you because you can then
purchase gold at Rs. 62,337 under this forwards contract and sell that gold in the spot
market at Rs. 62,700 i.e., net profit of Rs. 363 per 10 grams. Similarly, if the spot price is
62,100 on that day, then you incur a loss of Rs. 237 per 10 grams ( = buy price – sell price).
Major limitations of forwards
Liquidity Risk
Liquidity refers to the ability of the market participants to buy or sell the desired quantity
of an underlying asset. As forwards are tailor-made contracts i.e., the terms of the
contract are according to the specific requirements of the parties, other market
participants may not be interested in these contracts. Forwards are not listed or traded
on exchanges, which makes it difficult for other market participants to easily access these
contracts or contracting parties. The tailor-made contracts and their non-availability on
exchanges creates illiquidity in the contracts. Therefore, it is very difficult for parties to
exit from the forward contract before the contract’s maturity.
Counterparty risk
Counterparty risk is the risk of an economic loss from the failure of the counterparty to
fulfil its contractual obligation. For example, A and B enter into a bilateral agreement,
where A will purchase 100 kg of rice at Rs.40 per kg from B after 6 months. Here, A is
counterparty to B and vice versa. After 6 months, if price of rice is Rs.50 in the market
then B may decline his obligation to deliver 100 kg of rice at Rs.40 to A. Similarly, if price
of rice falls to Rs.35 then A may purchase from the market at a lower price, instead of
honouring the contract. Thus, a party to the contract may default on his obligation if there
is incentive to default. This risk is also called default risk or credit risk.
In addition to the illiquidity and counterparty risks, there are several issues like lack of
transparency, settlement complications as it is to be done directly between the
contracting parties. A simple solution to all these issues is to bring these contracts to the
centralized trading platform. This is what futures contracts do.

3.2 Futures contracts

Futures contracts were created to overcome the limitations of forwards. A futures
contract is an agreement made through an organized exchange to buy or sell a fixed
amount of a commodity or a financial asset on a future date at an agreed price. In simple
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terms, futures are standardised forward contracts that are traded on an exchange. The
clearing corporation associated with the exchange guarantees settlement of these trades.
A trader, who buys futures contract, takes a long position and the one, who sells futures,
takes a short position. The words buy and sell are figurative only because no money or
underlying asset changes hand, between buyer and seller, when the deal is originated.
Features of futures contracts
In a futures market, the exchange decides all the terms of the contract other than price.
Accordingly, futures contracts have following features:
• Contract between two parties through Exchange
• Centralised trading platform (i.e., Exchange)
• Price discovery through free interaction of buyers and sellers
• Margins payable by both the parties
• Quality decided today (standardized)
• Quantity decided today (standardized)
Limitations of Futures Contract
• As futures are standardized contracts introduced by the exchanges, they too have
certain limitations in the context of limited maturities, limited underlying set, lack
of flexibility in contract design and increased administrative costs on account of
MTM settlement, etc.

3.3 Contract specifications of futures contracts

The exchange decides all terms and conditions of futures contracts other than the price
of the futures contract. These terms and conditions are known as ‘contract specifications.
Contract specifications include the salient features of a derivatives contract like contract
maturity, contract multiplier or contract size, tick size, etc. Let us understand these
contract specifications with an example of a Nifty futures contract traded on the NSE.
Quotes given on the NSE website for Nifty futures as on Oct 03, 2024
1. Instrument type : Index futures
2. Underlying asset : Nifty 50
3. Expiry date : Oct 31, 2024
4. Open price (in Rs.) : 25670.10
5. High price (in Rs.) : 25818.15
6. Low price (in Rs.) : 25440.00
7. Closing price (in Rs.) : 25475.70
8. No of contracts traded : 1,17,48,150
9. Turnover (in Rs. Lakhs) : 30,07,617.27

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10. Underlying value (in Rs.) : 25250.10
Underlying instrument and underlying price: The underlying instrument refer to the
index or stock on which the futures contract is traded. In the above example, the
underlying asset is the Nifty 50 index. The underlying price is the spot price or the price
at which the underlying asset trades in the cash market. In this example, the underlying
price is the value of the Nifty index on May 10, 2023 which is 25250.10.
Contract multiplier or Contract Size: Futures contracts are traded in lots. The lot size or
contract size for the index and stock futures is determined by the exchange. Contract sizes
are different for each stock and index traded in the derivatives segment. The contract size
can be changed by the exchange from time to time, depending upon the changes in the
index level and stock prices. To arrive at the contract value, we must multiply the futures
price with the contract multiplier (i.e., multiply the futures price with the lot size). The
contract size for the Nifty futures contract is currently 25. In the above example, the value
of a Nifty futures contract can be calculated by multiplying the lot size with the closing
futures price i.e., 25 * 25475.70 which works out to Rs. 6,36,893.
Clause 1.1.4 and Clause 2.1.4 of SEBI Master Circular for Stock Exchanges and Clearing
Corporations dated October 16, 2023, stipulates contract size for index futures and index
options respectively. The current stipulation is for such contracts to have a value between
Rs. 5 lakhs and Rs. 10 lakhs. This limit was last set in 2015. Since then, broad market values
and prices have increased by around three times. Given this, SEBI has decided that a
derivative contract shall have a value not less than Rs. 15 lakhs at the time of its
introduction in the market. Further, the lot size shall be fixed in such a manner that the
contract value of the derivative on the day of review is within Rs. 15 lakhs to Rs. 20 lakhs.
This will lead to increase in Lot Size to the extent that the Contract value will fall between
Rs. 15 lakhs to Rs. 20 lakhs. These changes will be effective from Nov 2024.2
Contract Cycle: It is a period over which a contract trade. Index and stock futures
contracts traded on the NSE follow a three-month trading cycle. Thus, on Oct 03, 2024,
index and stock futures contracts on the NSE are available for trading for the near month
(Oct 2024), the next month (Nov 2024) and the far month (Dec 2024). The BSE offers
trading on monthly as well as weekly futures contracts.
Expiration Day: This is the day on which a derivative contract ceases to exist. It is the last
trading day of the contract. On expiry date, all the contracts are compulsorily settled. If a
position is to be continued, then it must be rolled over to another futures contract of the
same underlying. For a long position, this means selling the expiring contract and buying
the next contract. Both the sides of a roll over should be executed at the same time. The

2
SEBI Circular Ref :SEBI/HO/MRD/TPD-1/P/CIR/2024/132 Dated Oct 01, 2024

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Nifty and the Bank Nifty futures contracts and the stock futures contracts listed on the
NSE expire on the last Thursday and Last Wednesday of the respective month (or the day
before if the last Thursday / Wednesday (for Bank Nifty Future Contracts) is a trading
holiday). In the above example, the Oct Nifty futures contract will cease to trade on Oct
31, 2024 and all open positions of the Oct series will be compulsorily settled by the
exchange. A new contract (in this example - January 2025) is introduced on the trading
day following the expiry day of the near month contract. The monthly futures contracts
on the Nifty Financial Services Index expire on the last Tuesday of their expiry month.
Monthly and weekly futures contracts on the BSE Sensex and the BSE Bankex have
different expiration dates.
Tick Size: It is the minimum move allowed in the price quotations. Exchanges decide the
tick sizes on traded contracts as part of contract specification. Tick size for Nifty futures is
5 paisa. Bid price is the price the buyer is willing to pay and ask price is the price at which
the seller is willing to sell.
Daily settlement price: The exchange follows a daily settlement procedure for open
positions in equity index and stock futures contracts. All open positions are settled daily
based on the daily settlement price of the futures contracts, which is calculated by the
exchange on the basis of the last half-an-hour weighted average price of that futures
contract. Thus, the daily settlement price is different for each futures contract of a
different expiry month. In the above example, the daily settlement price of the Oct Nifty
futures contract on Oct 03 is its closing price which is 25475.70.
Final settlement price: This is the price at which all open positions in the near-month
futures contracts are finally settled on the expiration day of the near-month futures
contract. The final settlement price is the closing price of the relevant underlying index or
stock in the cash segment on the last trading day of the futures contract. In the above
example, the final settlement price for the Oct Nifty futures contract will be the closing
spot value of Nifty on the expiration date, i.e., on Oct 31, 2024 which is the last Thursday
of the expiry month.
Trading hours: The equity futures contracts can be traded during the normal market
hours between 9.15 am and 3.30 pm from Monday to Friday. The exchange publishes a
list of annual trading holidays and clearing holidays for the information of the market
participants. Trading holidays are days on which no trading is possible as the exchanges
are closed while clearing holidays are days on which the exchanges are open, and trading
is possible but no clearing and settlement takes place as banks are closed.

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The BSE Sensex futures contracts are based on the underying BSE Sensex. These contracts
have specifications that are somewhat different from the Nifty futures contracts as
follows:

Underlying asset BSE Sensex

Contract size 10

Tick size Rs.0.05

Contract cycle 7 serial weekly and 3 serial monthly

contracts

Trading hours 9:15 a.m. to 3.30 p.m.

Expiration day Monthly contracts: last Friday of the

contract month
Weekly contracts: Friday expiry

Final settlement Cash settlement based on the closing price

of the underlying index on the expiration
day

The high correlation between the movements of the Sensex and Nifty enables market
participants to trade in Nifty and Sensex futures as part of a pairs trading strategy. The
availability of weekly futures contracts on the Sensex and a different expiration day
(Friday) for the Sensex futures provides better trading and hedging opportunities to
market participants.

3.4 Some important terminology associated with futures contracts

Basis: The difference between the spot price and the futures price is called basis. If the
futures price is greater than spot price, basis for the asset is negative. Similarly, if the spot
price is greater than futures price, basis for the asset is positive. On Oct 03, 2024, spot
price < futures price, thus basis for Nifty futures is negative (i.e., 25250.10 – 25475.70 = -
225.60).
Importantly, basis for one-month contract would be different from the basis for two-or
three-month contracts. Therefore, definition of basis is incomplete until we define the
basis vis-a-vis a futures contract i.e., basis for one-month contract, basis for two-months
contract, etc. It is also important to understand that the difference in the basis of a one

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month futures contract and two months futures contract should essentially be equal to
the cost of carrying the underlying asset between first and second month. Indeed, this is
the fundamental principle of linking various futures and underlying cash market prices
together.
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. Further, whatever the basis is, positive or
negative, it becomes zero at maturity of the futures contract i.e., there should be no
difference between futures price and spot price at the time of maturity / expiry of
contract. This happens because final settlement of futures contracts on last trading day
takes place at the closing price of the underlying asset.
Cost of Carry
Cost of Carry is the relationship between futures prices and spot prices. It measures the
storage cost (in commodity markets) plus the interest that is paid to finance or ‘carry’ the
asset till delivery, less the income earned on the asset during the holding period. For
equity derivatives, carrying cost is the interest paid to finance the purchase less (minus)
dividend earned.
For example, assume the share of ABC Ltd is trading at Rs. 100 in the cash market. A
person wishes to buy the share but does not have money. In that case he would have to
borrow Rs. 100 at the rate of, say, 6% per annum. Suppose that he holds this share for
one year and in that year, he expects the company to give 200% dividend on its face value
of Rs. 1 i.e., dividend of Rs. 2. Thus his net cost of carry = Interest paid – dividend received
= 6 – 2 = Rs. 4. Therefore, break even futures price for him should be Rs.104. It is important
to note that cost of carry may be different for different participants.
Margin Account
As the exchange guarantees the settlement of all the trades, to protect itself against
default by either counterparty, it charges various margins from brokers. Brokers in turn
charge margins from their clients. Margins are briefly explained as follows:
Initial Margin
The amount one needs to deposit in the margin account at the time of entering into a
futures contract is known as the initial margin. Let us take an example - On May 14, 2024
a person decided to enter into a futures contract. He expects the market to go up and so
he takes a long Nifty Futures position for May expiry at Rs.22250.
The contract value = Nifty futures price * lot size = 22250 * 25 = Rs 5,56,250.
This is the contract value of the investor’s long position in one Nifty Future contract
expiring on May 30, 2024.

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Assuming that the broker charges 10% of the contract value as initial margin, the investor
has to give him Rs. 55,625 as initial margin. Both buyers and sellers of futures contract
pay initial margin, as there is an obligation on both the parties to honour the contract.
The initial margin is dependent on price movement of the underlying asset. As high
volatility assets carry more risk, the exchange would charge higher initial margin on them.
Marking to Market (MTM)
In futures market, while contracts have maturity of several months, profits and losses are
settled on day-to-day basis – called mark to market (MTM) settlement. The exchange
collects these margins (MTM margins) from the loss-making participants and pays to the
gainers on day-to-day basis.
Let us understand MTM with the help of the example. Suppose a trader bought a futures
contract on May 14, 2024 when the Nifty futures contract was trading at 22250. He paid
an initial margin of Rs. 55,625 as calculated above. At the end of that day, Nifty futures
contract closed at 22308.70. This means that the trader benefitted due to the 58.70 points
gain on Nifty futures contract. Thus, the trader’s MTM gain for the day was Rs 58.70 x 25
= Rs 1468. This money will be credited to the trader’s account and next day the trader’s
position will start from 22308.70 (for the purpose of MTM computation).
Open Interest and Volumes Traded
The open interest is the total number of contracts outstanding (yet to be settled) for an
underlying asset. It is important to understand that number of long futures as well as
number of short futures is equal to the Open Interest. This is because total number of
long futures will always be equal to total number of short futures. Only one side of
contracts is considered while calculating/mentioning open interest. The level of open
interest indicates depth in the market.
Volumes traded give us an idea about the market activity with regards to specific contract
over a given period – volume over a day, over a week or month or over the entire life of
the contract.
The following example explains the difference between open interest and traded volume.
Date Trade Open Interest as on date Trading
Volume for
the day

March 1 A shorts 50 contracts 50 50

B goes long in 50 contracts
March 2 C goes long in 100 contracts OI increases to 150 as new long 100
D goes short in 100 contracts and short position are created

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 March 3 A closes short position by OI remains at 150 because A’s 50
buying back 50 contracts short position is replaced by E’s
E shorts 50 contracts short position
March 4 C closes long position by OI falls to 50 as existing long 100
selling 100 contracts and D and short positions are closed
closes short position by
buying back 100 contracts
Price band
Price Band is essentially the price range within which a contract is permitted to trade
during a day. The band is calculated with respect to the previous day’s closing price of a
specific contract. For example, the previous day closing price of a contract is Rs.100 and
the price band for the contract is 10%, then the contract can trade between Rs.90 and
Rs.110 for next trading day. On the first trading day of the contract, the price band is
decided based on the closing price of the underlying asset in cash market. For example, if
today is first trading day of a futures contract for an underlying asset i.e., company A, the
price band for the contract is decided on the previous day’s closing price of company ‘A’
stock in cash market. Price band is clearly defined in the contract specifications so that all
market participants are aware of the same in advance. Sometimes, bands are allowed to
be expanded at the discretion of the exchanges with specific trading halts.
Positions in derivatives market
As a market participant, you will always deal with certain terms like long, short and open
positions in the market. Let us understand the meanings of commonly used terms:
Long position
Outstanding / unsettled buy position in a contract is called “Long Position”. For instance,
if Mr. X buys 5 contracts on Sensex futures, then he would be long on 5 contracts of Sensex
futures. If Mr. Y buys 4 contracts on Nifty futures, then he has a long position in 4 contracts
of Nifty futures.
Short Position
Outstanding / unsettled sell position in a contract is called “Short Position”. For instance,
if Ms. P sells 5 contracts on Sensex futures, then she would be short on 5 contracts on
Sensex futures. If Ms. Q sells 4 contracts on Nifty futures, then she would be short on 4
contracts of Nifty futures.
Open position
Outstanding / unsettled either long (buy) or short (sell) position in various derivative
contracts is called “Open Position”. For instance, if Mr. X shorts 5 contracts on Infosys
futures and goes long on 3 contracts of Reliance futures, he is said to be having open

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position, which is equal to short on 5 contracts of Infosys and long on 3 contracts of
Reliance. If on the next day, he buys 2 Infosys contracts of same maturity, his open
position would be – short on 3 Infosys contracts and long on 3 Reliance contracts.
Naked and calendar spread positions
Naked position in futures market simply means a long or short position in any futures
contract without having any position in the underlying asset. Calendar spread position is
a combination of two positions in futures on the same underlying - long on one maturity
contract and short on a different maturity contract.
For instance, a short position in near month contract coupled with a long position in far
month contract is a calendar spread position. Calendar spread position is computed with
respect to the near month series and becomes an open position once the near month
contract expires or either of the offsetting positions is closed.
A calendar spread is always defined with respect to the relevant months i.e., spread
between August contract and September contract, spread between August contract and
October contract, or spread between September contract and October contract, etc.
Opening a position
Opening a position means either buying or selling a contract, which increases client’s open
position (long or short).
Closing a position
Closing a position means either buying or selling a contract, which essentially results in
reduction of client’s open position (long or short). A client is said to be closed a position
if he sells a contract which he had bought before, or he buys a contract which he had sold
earlier.

3.5 Differences between Forwards and Futures

Feature Forward contracts Futures contracts
Operational It is not traded on the It is an exchange-traded contract.
mechanism exchanges.
Contract Terms of the contracts differ Terms of the contracts are
specifications from trade to trade (tailor made standardized. Except the price, all
contract) according to the need other terms of the contract are
of the participants. already fixed (standardized).
Counter-party Exists, but at times gets reduced The clearing agency associated
risk by a guarantor. with exchange becomes the
counter-party to all trades

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 assuring guarantee on their
settlement.
Liquidity Low, as contracts are tailor- High, as contracts are
profile made catering to the needs of standardised and exchange
the parties involved. Further, traded.
contracts are not easily
accessible to other market
participants.
Price discovery Not efficient, as markets are Efficient, centralised trading
scattered. platform helps all buyers and
sellers to come together and
discover the price through
common order book.
Quality of Quality of information may be Futures are traded nationwide.
information poor. Speed of information Every bit of relevant information
and its dissemination is slow. is quickly disseminated.
dissemination

3.6 Payoff Charts for Futures contracts

Payoff Charts
Payoff on a position is the likely profit/loss that would accrue to a market participant with
change in the price of the underlying asset at expiry. The payoff diagram is a graphical
representation showing the price of the underlying asset on the X-axis and profits/losses
on the Y-axis.
Payoff charts for futures
In case of futures contracts, long as well as short position has unlimited profit or loss
potential. This results into linear payoffs for futures contracts. Futures payoffs are
explained in detail below:
Payoff for buyer of futures: Long futures
Let us say a person goes long in a futures contract at Rs.100. This means that he has
agreed to buy the underlying at Rs. 100 on expiry. Now, if on expiry, the price of the
underlying is Rs. 150, then this person will buy at Rs. 100, as per the futures contract and
will immediately be able to sell the underlying in the cash market at Rs.150, thereby
making a profit of Rs. 50. Similarly, if the price of the underlying falls to Rs. 70 at expiry,
he would have to buy at Rs. 100, as per the futures contract, and if he sells the same in
the cash market, he will receive only Rs. 70, translating into a loss of Rs. 30.

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This potential profit/loss at expiry when expressed graphically, is known as a payoff chart.
The X Axis has the market price of the underlying at expiry. It increases on the Right-Hand
Side (RHS). We do not draw the X Axis on the Left-Hand Side (LHS), as prices cannot go
below zero. The Y Axis shows profit & loss. In the upward direction, we have profits and
in the downward direction, we show losses in the chart.
The below table and payoff chart show long futures pay offs:
Long Futures at 100
Market price Long Futures
at expiry Payoff
50 -50
60 -40
70 -30
80 -20
90 -10
100 0
110 10
120 20
130 30
140 40
150 50

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 60
Long Futures Payoff

40

20
Profit/Loss (Rs.)

0
50 60 70 80 90 100 110 120 130 140 150

CMP @ Expiry

-20

-40

Long Futures Payoff

-60

Short Futures payoff

As one person goes long, some other person must go short, otherwise a deal will not take
place. The profits and losses for the short futures position will be exact opposite of the
long futures position. This is shown in the table and chart below:
Short Futures at 100
Market price Short Futures
at expiry Payoff
50 50
60 40
70 30
80 20
90 10
100 0
110 -10
120 -20
130 -30
140 -40
150 -50

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 60
Short Futures Payoff

40

20
Profit/Loss (Rs.)

0
50 60 70 80 90 100 110 120 130 140 150

CMP @ Expiry

-20

-40

Short Futures Payoff

-60

As can be seen, a short futures position makes profits when prices fall. If prices fall to 60
at expiry, the person who has shorted at Rs.100 will buy from the market at 60 on expiry
and sell at 100, thereby making a profit of Rs. 40. This is shown in the above chart.

3.7 Futures pricing

Pricing of a futures contract depends on the characteristics of underlying asset. There is
no single way to price futures contracts because different assets have different demand
and supply patterns, different characteristics and cash flow patterns. This makes it
difficult to design a single methodology for calculation of prices of futures contracts.
Market participants use different models for pricing futures. Here, our discussion is
limited to only two popular models of futures pricing - Cost of Carry model and
Expectations model.
Cost of Carry Model for Futures Pricing
Cost of Carry model is also known as the no-arbitrage model. This model assumes that in
an efficient market, arbitrage opportunities cannot exist. In other words, the moment
there is an opportunity to make money in the market due to mispricing in the asset price
and its replicas, arbitrageurs will start trading to profit from these mispricing and thereby
eliminating these opportunities. This trading continues until the prices are aligned across
the products/markets for replicating assets.

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Let us understand the entire concept with the help of an example. Practically, forward/
futures position in a stock can be created in the following manner:
• Enter into a forward/futures contract, or
• Create a synthetic forward/futures position by buying that stock in the cash
market and carrying it to the future date.
The price of acquiring the asset by a future date should be the same in both the cases i.e.,
cost of synthetic forward/futures contract (= spot price + cost of carrying the asset from
today to the future date) should be equivalent to the present price of the forward/ futures
contract. If these prices are not the same, then it will trigger arbitrage and will continue
until prices in both the markets are aligned.
The cost of creating a synthetic futures position is the fair price of futures contract. Fair
price of futures contract is nothing but the sum of spot price of underlying asset and cost
of carrying the asset from today until delivery. Cost of carrying a financial asset from today
to the future date would entail different costs like transaction cost, custodial charges,
financing cost, etc. and for commodities, it would also include costs like warehousing cost,
insurance cost, etc.
Let us take an example from the bullion market. Assume that the spot price of gold is Rs
62,130 per 10 grams. The cost of financing, storage and insurance for carrying the gold
for a period of three months is Rs 100 per 10 grams. Now you purchase 10 grams of gold
from the market at Rs 62,130 and hold it for three months. We may now say that the
expected value of the gold after 3 months would be Rs 62,230 per 10 grams.
Assume the 3-month futures contract on gold is trading at Rs 62,280 per 10 grams. What
should one do? Apparently, one should attempt to exploit the arbitrage opportunity
present in the gold market by buying gold in the cash market and sell 3-month gold
futures simultaneously. We borrow money to take delivery of gold in cash market today,
hold it for 3 months and deliver it in the futures market on the expiry of our futures
contract. Amount received on settling the futures contract could be used to repay the
financier of our gold purchase. The net result will be a profit of Rs 50 without taking any
risk. (Please note that we have not considered any transaction costs in this example).
Because of this mispricing, as more and more people come to the cash market to buy gold
and sell in futures market, spot gold price will go up and gold futures price will come
down. This arbitrage opportunity continues until the prices between cash and futures
markets are aligned. Therefore, if futures price is more than the fair futures price, it will
trigger “cash and carry arbitrage”, which will continue until the prices in both the markets
are aligned.

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Similarly, if the futures price is less than the fair futures price, it will trigger “reverse cash
and carry arbitrage” i.e., market participants will start buying gold in futures markets and
sell gold in cash market. To do this, traders will borrow gold and deliver it to honour the
contract in the cash market and earn interest on the cash market sales proceeds. After
three months, they give gold back to the lender on receipt of the same in futures market.
This reverse arbitrage will result in reduction of gold’s spot price and increase of its
futures price, until these prices are aligned and there is no further arbitrage left.
Cost of transaction and no-arbitrage bounds
Cost components of futures transaction like margins, transaction costs (commissions),
taxes etc. create distortions and move the markets away from equilibrium. In fact, these
cost components create no-arbitrage bounds in the market i.e., if the futures price is
within these bounds around the fair futures price, arbitrage will not take place. In other
words, because of the frictions in the market, for arbitrage to get triggered, it is important
for the futures price to fall outside the no-arbitrage bounds in either direction for the
arbitragers to make profit from the arbitrage opportunities.

Fair Price

No-arbitrage bounds
Practically, every component of carrying cost contributes towards widening of these no-
arbitrage bounds. Here, we should appreciate that wider the no-arbitrage bounds, farther
the markets are from the equilibrium. In other words, for the markets to be efficient,
different costs of operating in the markets should be as low as possible. Lower costs would
narrow the no-arbitrage bounds, which in turn would ensure the efficient price alignment
across the markets.
Extension of Cost of Carry model to the assets generating returns
Let us extend the Cost of Carry model by adding the inflows during the holding period of
underlying assets. For instance, underlying assets like securities (equity or bonds) may
have certain inflows, like dividend on equity and interest on debt instruments, during the
holding period. These inflows are adjusted in the computation of the fair futures price.
Thus, modified formula of fair futures price or synthetic futures price is:
Fair futures price = Spot price + Cost of carry - Inflows
In mathematical terms, F = S (1+r-q)T

41
Where F is fair price of the futures contract, S is the Spot price of the underlying asset, q
is expected return during holding period T (in years) and r is cost of carry.
If we use the continuous compounding, we may rewrite the formula as: F= Se(r-q)*T
Let us apply the above formula to the index futures market to find the fair futures price
of an index. Suppose, you buy an index in cash market at 17500 level i.e., purchase of all
the stocks constituting the index in the same proportion as they are in the index, cost of
financing is 12% and the return on index is 4% per annum (spread uniformly across the
year). Given this data, fair price of index three months down the line should be:
= Spot price * (1 + cost of financing – holding period return) ^ (time to expiration / 365)
= 17500 * (1+0.12-0.04) ^ (90/365)
= Rs. 17835.26
[Alternatively, we could use exponential form for calculating the futures value as: Spot
Price * e(r-q)T. Value in that case would have been: 17500*e((0.12-0.04)*90/365) = Rs. 17848.63].
If the index futures is trading above 17848.63, we can buy index stocks in the cash market
and simultaneously sell index futures to lock the gains equivalent to the difference
between futures price and fair futures price. Note that the cost of transaction, taxes,
margins, etc. are not considered while calculating the fair futures price.
Note: Cost of borrowing of funds and securities, return expectations on the held asset,
etc. are different for different market participants. Perhaps the different fair values of
futures contracts and no-arbitrage bounds for different market participants is what makes
the market and trading take place on a continuous basis.
Assumptions of the Cost of Carry model
This model of futures pricing works under certain assumptions. The important
assumptions are stated below (*):
• The underlying asset is available in abundance in cash market.
• Demand and supply in the underlying asset are not seasonal.
• Holding and maintaining of the underlying asset is easy and feasible.
• The underlying asset can be sold short.
• There are no transaction costs.
• There are no taxes.
• There are no margin requirements.
[*This is not an exhaustive list of the assumptions of the model but is the list of important assumptions]

The assumption that the underlying asset is available in abundance in the cash market
means that we can buy and/or sell as many units of the underlying assets as we want.
This assumption does not work especially when the underlying asset has a seasonal
pattern of demand and supply. The prices of seasonal assets (especially commodities)

42
vary drastically in different demand-supply environments. For example, in case of
agricultural commodities, when new supplies arrive in the marketplace, prices tend to
fall, whereas prices tend to be high just before the arrival of that new supply.
When an underlying asset is not storable i.e., the asset is not easy to hold/maintain, then
one cannot carry the asset to the future. The Cost of Carry model is not applicable to these
types of underlying assets.
Similarly, many a time, the underlying may not be sold short. This is true in case of
seasonal commodities.
Even though this simple model does not discount for transaction cost, taxes, etc., we can
always upgrade the formula to reflect the impact of these factors in the model. Margins
are not considered while computing the fair value/ synthetic futures value. That is why
this model is suitable for pricing forward contracts rather than futures contracts.
Thus, no generalized statement can be made with regard to the use of Cost of Carry model
for pricing futures contracts. Assumptions of the model and characteristics of underlying
asset can help us in deciding whether a specific asset can be priced with the help of this
model or not. Further, suitable adjustments are made in the model to fit in the specific
requirements of the underlying assets.

Convenience Yield
Let us touch upon one more concept in futures market called “Convenience Yield”. We
need to go back and have a look at the formula for fair price of futures contract.
Fair price of futures contract = Spot price + Cost of carry – Inflows
As seen earlier inflows may be in the form of dividend (in case of equity) and interest (in
case of debt). However, sometimes inflows may also be intangibles. Intangible inflows
essentially mean values perceived by the market participants by holding the asset. These
values may be in the form of convenience or perceived mental comfort by holding the
asset.
For instance, in case of a natural disaster like a flood in a particular region, people start
storing essential commodities like grains, vegetables and energy products (heating oil),
etc. As a human tendency, we store more than what is required for our real consumption
during a crisis. If every person behaves in similar way, then suddenly a demand is created
for an underlying asset in the cash market. This indirectly increases the price of underlying
assets. In such situations people derive convenience, just by holding the asset. This is
termed as convenience yield or convenience return.

43
Convenience yield for a commodity is likely to be different for different people, depending
on the way they use it or perceive it. Further, it may vary over a period. In fact,
convenience is a subjective issue and is very difficult to price.
Convenience yield sometimes may dominate the cost of carry, which leads futures to
trade at a discount to the cash market. In this case, reverse arbitrage is also not possible
because no one lends traders the assets to sell short in the cash market. In such situations,
practically, the cash and carry model breaks down and cannot be applied for pricing the
underlying assets.
Note that the convenience yield mainly arises when there is a scarcity of a commodity
(for example, crop failure due to natural calamities) and its inventory is low. Hence,
convenience yield is usually observed in case of consumption assets (i.e., commodities)
and not in case of financial assets (such as equities, bonds or currencies).
Expectations model of futures pricing
According to the expectations hypothesis, it is not the relationship between spot and
futures prices, but that of expected spot and futures prices, which moves the market,
especially in cases when the asset cannot be sold short or cannot be stored. It also argues
that futures price is nothing but the expected spot price of an asset in the future. This is
why market participants would enter futures contract and they price the futures based
upon their estimates of the future spot prices of the underlying assets. According to this
model:
• Futures can trade at a premium or discount to the spot price of underlying asset.
• Futures price gives market participants an indication of the expected direction of
movement of the spot price in the future.
For instance, if futures price is higher than spot price of an underlying asset, market
participants may expect the spot price to rise in the near future. This expectedly rising
market is called “Contango market”. Similarly, if futures price is lower than spot price of
an asset, market participants may expect the spot price to fall in future. This expectedly
falling market is called “Backwardation market”.

3.8 Price discovery and convergence of cash and futures prices on the expiry
It is important to understand what the expectations hypothesis means. For instance, if we
say that the May 2024 index futures contract is trading at 22308.70 on May 14, 2024,
what does it mean? According to the expectations model of futures pricing, it means that
as on May 14, the market expects the spot index to settle at 22308.70 at the closure of
the market on last Thursday of May 2024 (i.e., on the last trading day of the contract
which is May 30, 2024). The point is that every participant in the market is trying to predict
the spot index level at a single point in time i.e., at the closure of the market on last trading

44
day of the contract, which is Thursday in our example. This results in price discovery of
spot index at a specific point in time. Thus, the futures prices are essentially expected spot
price of the underlying asset, at the maturity of the futures contract. Accordingly, both
futures and spot prices converge at the maturity of futures contract, as at that point in
time there cannot be any difference between these two prices. This is the reason why all
futures contracts on expiry settle at the underlying cash market price. This principle
remains the same for all the underlying assets.

3.9 Uses of futures

Role of different participants in derivatives markets
The participants in the derivatives markets can be categorized as hedgers, speculators
and arbitrageurs.
Hedgers
Corporations, Investing Institutions, banks and governments all use derivative products
to hedge or reduce their exposures to market variables such as interest rates, share
values, bond prices, currency exchange rates and commodity prices. The classic example
is the farmer who sells futures contracts to lock into a price for delivering a crop on a
future date. The buyer might be a food-processing company, which wishes to fix a price
for taking delivery of the crop in the future. Another example could be that of an investor
with a diversified equity portfolio, who wants to protect his portfolio from any temporary
correction in the stock market. Such an investor could sell index futures for this purpose.
Speculators/Traders
Futures contracts are very well suited to trading on the prices of financial assets and
commodities. It is much less expensive to create a speculative position using futures than
by actually trading the underlying asset. As a result, the potential returns are much
greater. A classic application is the trader who believes that the announcement of better-
than-expected quarterly results of a company will boost the stock price of that company.
He has two options: the first alternative is to buy and hold the equity shares of the
company whereas the other alternative is to go long the futures contracts of that stock.
If the trader chooses the second option to go long futures contract on the underlying
stock and the stock price increases, the value of the contract will also rise, and he can
square-off the position to book his profit. Of course, if the trader takes a long position and
the stock price falls, the futures price will also fall, leaving the trader with a large loss.
Leverage acts as a ‘double-edged’ sword. Therefore, positions in futures contracts, which
are basically leveraged instruments, are riskier in nature than buying or selling the
underlying asset itself.
Arbitrageurs

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An arbitrage is a deal that produces risk-free profits by exploiting a mispricing in the
market. A simple arbitrage occurs when a trader purchases an asset cheaply in one
location/ exchange and simultaneously arranges to sell it at another location/ exchange
at a higher price. Such opportunities are unlikely to persist for very long, since
arbitrageurs would rush in to buy the asset in the cheaper market and simultaneously sell
it in the expensive market, thus reducing the pricing gap.
As mentioned above, there are three major players in derivatives market – Hedgers,
Traders, and Arbitrageurs. Hedgers aim to hedge their risk, traders take the risk which
hedgers plan to offload from their exposure and arbitrageurs establish an efficient link
between different markets.
Traders take naked positions in the futures market i.e., they go long or short in various
futures contracts available in the market. Indeed, the capacity of derivatives market to
absorb buying/selling by hedgers is directly dependent upon availability of traders, who
act as counter-party to hedgers. Thus, traders form one of the most important
participants of the derivatives market, providing depth to the market. Hedgers may not
be able to hedge, if traders were not present in the system. Therefore, the presence of
both hedgers and traders is essential for the growth of the futures market.
For instance, assume, a farmer expects the price of wheat to fall in near future. He wants
to hedge his price risk on wheat produce for next 3 months till the time he has actual
produce in his hands and so would like to lock in the forward/ futures price now.
Accordingly, the farmer can sell futures contracts on the expected quantity of produce. In
order to sell this futures contract, he needs a buyer. This buyer may be someone who
needs wheat after three months, may be a flour mill or a bakery. However, most of the
times, there is a demand supply mismatch in the market and the trader fills the gap
between demand and supply.
Here the trader, who is a counterparty to the farmer, has a contrary view i.e., this buyer
will buy only if he thinks that the actual price of wheat three months down the line is
going to be higher than the three-month futures price today. Further, the profit of the
trader would depend upon actual wheat price being more than the contracted futures
price at the maturity of futures contract. If that happens, the trader will make money, else
he would lose money.
In addition to hedgers and traders, to establish a link between various markets like spot
and derivatives, we need a third party called the arbitrageur. These arbitragers
continuously hunt for the profit opportunities across the markets and products and seize
those by executing trades in different markets and products simultaneously. Importantly,
arbitrageurs generally lock in their profits unlike traders who trade naked contracts.
For example, at the end of day:

46
Market price of underlying asset (in Rs.) 100
May futures 110
Lot size 50
Here an arbitrageur will buy in the cash market at Rs. 100 and sell in the Futures market
at Rs. 110, thereby locking Rs. 10 as his profit on each share.
On the expiration date, suppose price (in Rs.) of the underlying asset is 108.
Cash Market Futures
Buy 100 Sell 110
Sell 108 Buy 108
+8 +2
Total profit would be Rs 2 + Rs 8 = Rs 10 per unit and Rs 10 * 50 = Rs 500 for the lot.
Suppose price (in Rs.) of the underlying asset is 95 on the expiration date.
Cash Market Futures
Buy 100 Sell 110
Sell 95 Buy 95
-5 +15
Total profit would be Rs 15 - Rs 5 = Rs 10 per unit and Rs 10 * 50 = Rs 500 for the lot.
Transaction costs and impact cost have not been considered in the above example. In real
life, the transaction costs such as brokerage, Service Tax, Securities Transaction Tax, etc.
must be considered.
Here, it may be interesting to look at the risks these arbitrageurs carry. As seen before,
arbitrageurs execute positions in two or more markets/products simultaneously. Even if
the systems are seamless and electronic and both the legs of transaction are liquid, there
is a possibility of some time lag between the execution of both the orders. If either leg of
the transaction is illiquid then the risk on the arbitrage deal is huge as only one leg may
get executed and another may not, which would open the arbitrager to the naked
exposure of a position. Similarly, if contracts are not cash settled in both or one of the
markets, it would need reversal of trades in the respective markets, which would result
in additional risk on unwinding position with regard to simultaneous execution of the
trades.
These profit focused traders and arbitrageurs fetch enormous liquidity to the products
traded on the exchanges. This liquidity in turn results in better price discovery, lesser cost
of transaction and lesser manipulation in the market.
Uses of Index futures
Equity derivatives instruments facilitate trading of a component of price risk, which is
inherent to investment in securities. Price risk is the price movement of the asset held by

47
a market participant, in an unfavourable direction. This risk is broadly divided into two
parts: (i) specific risk or unsystematic risk, and (ii) market risk or systematic risk.
Unsystematic Risk
Specific risk or unsystematic risk is the component of price risk that is unique to specific
events pertaining to the company and/or industry. Examples of specific risk include the
risk of a fall in stock price due to a strike by factory workers which affects the production
and sales, the risk of sudden departure of key managerial personnel, risk of loss of market
share due to emergence of a strong competitor etc. Specific risk is inseparable from
investing in the securities. This risk could be reduced to a certain extent by diversifying
the portfolio.
Systematic Risk
An investor can diversify his portfolio and eliminate a major part of price risk i.e., the
diversifiable/unsystematic risk. What is left is the non-diversifiable portion or the market
risk, known as systematic risk. Variability in a security’s total returns that are directly
associated with overall movements in the general market or economy is called systematic
risk. Examples of market risk or systematic risk include risk due to a sudden change in the
monetary or fiscal policy, depreciation of domestic exchange rates, declaration of war,
etc. Thus, every portfolio is exposed to market risk. This risk is separable from the
investment and tradable in the market with the help of index-based derivatives.
Therefore, the total price risk in a stock investment is the sum of systematic risk (i.e.,
market risk) and unsystematic risk (i.e., risk specific to that stock).
We can use single stock futures to manage the risk of the equity investment in the spot
market. For instance, use of single stock futures would hedge the market participant
against the total risk in the equity investment because these futures are comparable with
underlying positions. The main difference between an underlying position and single
stock futures is on the settlement front: in case of cash transactions, settlement takes
place immediately and in case of futures contracts, settlement is deferred.
While single stock futures enable the investor to hedge the specific risk of a stock, index
futures are required to mitigate the systematic risk of a stock portfolio. Before we get to
the management of systematic risk with index futures, we need to understand beta - a
measure of systematic risk of a security that cannot be avoided through diversification. It
measures the sensitivity of a stock / portfolio vis-a-vis index movement over a period, on
the basis of historical prices. Suppose a stock has a beta equal to 2. This means that
historically this stock’s price has moved 20% when the index moved 10%, indicating that
this stock is more volatile than the index. Stocks (or portfolios) having beta more than 1
are called aggressive stocks (or aggressive portfolios) and those having beta less than 1
are called conservative stocks (or conservative portfolios).

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Betas of individual stocks are used to calculate beta of a portfolio. Portfolio beta is a
weighted average of betas of individual stocks in the portfolio based on their investment
proportion. For example, if there are four stocks in a portfolio with betas 0.5, 1.1, 1.30
and 0.90 having weights 35%, 15%, 20% and 30% respectively, the beta of this portfolio
would be 0.87 ( = 0.5*0.35 +1.10*0.15 +1.30*0.20 +0.90*0.30).
A generalized formula for portfolio beta can be written as W1 β1+W2 β2+…+ Wn βn= βp
Where, W1 is weight of stock 1, β1 is the β of stock 1, W2 is weight of stock 2, β2 is the β
of stock 2, …, Wn is weight of stock n, βn is the β of stock n and βp is the β of portfolio.
Please note that sum of the weights will be equal to 1 (i.e., W1+W2+…+Wn = 1).
Information on beta of individual stocks is readily available in various financial
newspapers, magazines and information vending networks like Bloomberg, Reuters, etc.
When stock futures are used to hedge the risk of a single stock, we can use a hedge ratio
of 1:1. For instance, suppose that an investor holds 550 shares of HDFC Bank and this is
her only investment. If the investor is worried about a temporary fall in the stock price
due to some company-specific news, she can use futures on HDFC Bank stock to hedge
her shareholding. Since the contract size of HDFC Bank futures is 550, she can use 1
futures contract to hedge her holding of 550 shares. Thus, a 1:1 hedge ratio can be used
to compute the number of futures contracts required to hedge the risk. But futures
contracts are available only on a limited set of stocks and hence we can use index futures
to hedge the remaining stocks which do not have their own futures contracts..
When index futures are used to manage the systematic risk of a portfolio, we cannot use
a hedge ratio of 1:1. This is because the portfolio to be hedged is different from the
hedging instrument, which is the index futures contract. Suppose that the investor holds
a portfolio comprising of 10 large-cap stocks and wishes to hedge this portfolio with an
index futures contract. Now, the index futures contract may represent an index
comprising 30 or 50 stocks and hence it is not a perfect hedge for the investor’s portfolio
that includes just 10 stocks. Moreover, the beta of this portfolio may be different from
that of the index. Hence, a 1:1 hedge ratio is not appropriate for this situation. To find the
number of contracts of index futures required for hedging this portfolio’s risk, the hedge
ratio is calculated as follows:
Number of contracts for hedging portfolio risk = Vp * βp / Vi
Vp: Value of the portfolio
Βp: Beta of the portfolio
Vi: Value of index futures contract
Value of index futures contract or contract size = futures index level * contract multiplier.
For simplification purpose, beta of futures index vis-a-vis spot index is taken as one.

49
Hedge against the systematic risk mainly depends upon the relationship of the portfolio
with the index, which is measured by beta. A portfolio has different relationships with
different indices used for hedge. Hence, the hedge ratio would change with the change in
the index. Further, there is an assumption that the past relationship between the stock’s
or portfolio’s movement and the index movement would continue in future. This may
result in some difference between actual and expected numbers.
Hedging using single stock futures and index futures is explained in detail in Unit 5 with
specific examples.
Important terms in hedging
Long hedge: Long hedge is the transaction when we hedge our position in cash market
by going long in futures market. For example, we expect to receive some funds in future
and want to invest the same amount in the securities market. We have not yet decided
the specific company/companies, where investment is to be made. We expect the
market to rise in the near future and bear a risk of acquiring the securities at a higher
price. We can hedge by going long index futures today. On receipt of money, we may
invest in the cash market and simultaneously unwind corresponding index futures
positions. Any loss due to acquisition of securities at higher price, resulting from the
upward movement in the market over this intermediate period, would be partially or
fully compensated by the profit made on our position in index futures.
Further, while investing, suitable securities at reasonable prices may not be immediately
available in sufficient quantity. Rushing to invest all money is likely to drive up the prices
to our disadvantage. This situation can also be taken care of by using the futures. We may
buy futures today, gradually invest money in the cash market and unwind corresponding
futures positions.
Short hedge: Short Hedge is a transaction when the hedge is accomplished by going
short in futures market. For instance, assume, we have a portfolio and want to liquidate
it in the near future but we fear that the prices will fall in near future. This may go
against our plan and may result in reduction in the portfolio value. To protect our
portfolio’s value, today, we can short index futures of an equivalent amount. The
amount of loss made in cash market will be partly or fully compensated by the profits on
our futures positions.

Cross hedge: When a futures contract on an asset is not available, market participants
look for an asset that is closely associated with their underlying and trade in the futures
market of that closely associated asset, for hedging purpose. They may trade in futures
of this related asset to protect the value of their actual asset. This is called cross hedge.

50
For instance, if futures contracts on jet fuel are not available in the international markets
then hedgers may use contracts available on other energy products like crude oil, heating
oil or gasoline due to their close association with jet fuel for hedging purpose. This is an
example of cross hedge.
Indeed, in a crude sense, we may say that when we use index futures to hedge against
the market risk on a portfolio, we are essentially establishing a cross hedge because we
are not using the exact underlying to hedge the risk.
Hedge contract month: Hedge contract month is the maturity month of the contract
through which we hedge our position. The thumb rule is to select that futures contract
which expires just after the date on which we wish to unwind our exposure. For
example, suppose that on May 10, an investor decides to sell his portfolio on June 20 to
meet some financial obligation. He wants to hedge the market risk of his portfolio by
shorting index futures. In this case, the investor should short the index futures contract
expiring in June 2024, and not in May 2024.

Trading in futures market

Traders are risk takers in the derivatives market. And they take positions in the futures
market without having any position in the underlying cash market. These positions are
based upon their expectations on price movement of underlying asset. Traders either
take naked positions or spread positions.
A trader takes a naked long position when he expects the market to rise. Profit is made
by reversing the long position at a higher price later. Similarly, he takes a short position
when he expects the market to fall and books a profit by reversing his position at a lower
price in the future. For instance, if one month Sensex futures contract is trading at 61000
and a trader expects the spot index at the maturity of the one-month contract would
settle at a level higher than this, he would take a long position in index futures at a level
of 61000. If his expectation comes true and index on maturity settles beyond 61000, this
trader will make money to the extent of the difference between buy price and sell price
(or, between buy price and settlement price) of the index.
Traders may also take long/short positions in single stock futures. When they expect the
stock price to rise, they may take long position in these futures and when they expect the
stock price to fall, they may take short position in single stock futures.
If the market or the stock moves in the expected direction, the trader would end up
making profit. Here, it may be noted that if the market or stock does not move in the
anticipated direction, the trader may also incur a loss. A futures position is as exposed to
loss as to profit.

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A naked position is long or short in any of the futures contracts but a spread position
consists of two opposite positions (one long and one short), either in two contracts with
the same maturity on different products, or in two contracts with different maturities on
the same product. The former is termed an inter-commodity or inter-product spread and
the latter is known as calendar spread/time spread or horizontal spread. Exchanges need
to provide the required inputs to the trading system for it to recognize any kind of spread.
At present, only calendar spreads are available for trading in the equity derivatives
segment. Inter-commodity spreads between specific commodities like gold and silver;
soybean, soybean meal and soybean oil, etc. are available for trading in the commodity
derivatives segment.
A calendar spread position is always computed with respect to the near month series. For
instance, if Mr. A has say 3 contacts short in one-month futures contract, 2 contracts long
in two-months futures contract and 3 contracts long in three-months futures contract, he
would be said to have 2 calendar spreads between first and second months and 1 calendar
spread between first and third month. Further, his position in remaining 2 three-months
contracts would be treated as naked. A calendar spread becomes a naked/open position,
when the near month contract expires or either of the legs of spread is closed. As spread
positions are hedged to a large extent because they are combinations of two opposite
positions, they are treated as conservatively speculative positions.
Arbitrage opportunities in futures market
Arbitrage is the simultaneous purchase and sale of an asset or replicating asset in the
market in an attempt to profit from discrepancies in their prices. Arbitrage involves
activity on one or several instruments/assets in one or different markets, simultaneously.
Important point to understand is that in an efficient market, arbitrage opportunities may
exist only for a brief period, or not at all. The moment arbitragers spot an arbitrage
opportunity, they initiate the arbitrage trades, thereby eliminating that arbitrage gap.
Arbitrage occupies a prominent position in the futures world as a mechanism that keeps
the prices of futures contracts aligned properly with the prices of the underlying assets.
The objective of arbitragers is to make profits without taking risk, but the complexity of
this activity is such that it may result in losses as well. Well-informed and experienced
professional traders, equipped with powerful calculating and data processing tools,
normally undertake arbitrage trades.
Arbitrage in the futures market can typically be of three types:
• Cash and carry arbitrage: Cash and carry arbitrage refers to a long position in the
cash or underlying market and a short position in futures market.
• Reverse cash and carry arbitrage: Reverse cash and carry arbitrage refers to long
position in futures market and short position in the underlying or cash market.

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 • Inter-Exchange arbitrage: This arbitrage entails two positions on the same
contract in two different markets/exchanges.
In the language of simple mathematics, Fair futures price F = S + C
where S stands for Spot price and C stands for Holding costs/carrying costs.
If cost of carry is defined in the percentage terms, we may redefine the formula as:
F = S(1+r)T
Where r is the carrying cost (in percentage) and T is the Time to expiration (in years).
If we use continuous compounding for computation of the cost, the same formula
reduces to:
F= SerT
If futures price is higher than fair/theoretical price, there would exist a profitable, risk-
free, cash and carry arbitrage opportunity. On the other hand, if the futures price is lower
than the fair futures price, there could be a profitable opportunity for reverse cash-carry
arbitrage. Thus, unless there are obstacles to such arbitrage, the activities of the
arbitrageurs would cause spot-futures price relationships to conform to that described by
the cost of carry formula. On rare occasions, however, there is an arbitrage opportunity
that exists for some time. Practically, an arbitrage is feasible and will be undertaken only
if it provides net cash inflow after transaction costs, brokerage, margin deposits, etc.
Arbitrage strategies are explained in detail in Unit 5 with examples.
Inter-market arbitrage
This arbitrage opportunity arises because of some price differences existing in the same
underlying at two different exchanges. If August futures on stock Z are trading at Rs. 101
at NSE and Rs. 100 at BSE, the trader can buy a contract at BSE and sell at NSE. The
positions could be reversed over a period of time when difference between futures prices
squeeze. This would be profitable to an arbitrageur.
It is important to note that the cost of transaction and other incidental costs involved in
the deal must be analysed properly by the arbitrageurs before entering into the
transaction.
In the light of above, we may conclude that futures provide market participants with a
quick and less expensive mode to alter their portfolio composition to arrive at the
desired level of risk. As they could be used to either add risk to the existing portfolios or
reduce risk of the existing portfolios, they are essentially risk management and portfolio
restructuring tools.

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Sample questions

1. You sold one XYZ Stock Futures contract at Rs. 278 and the lot size is 1,200. What is
your profit (+) or loss (-), if you purchase the contract back at Rs. 265?
(a) 16,600
(b) 15,600
(c) -15,600
(d) -16,600

2. You have taken a short position of one contract in June XYZ futures (contract multiplier
50) at a price of Rs. 3,400. When you closed this position after a few days, you realized
that you made a profit of Rs. 10,000. Which of the following closing actions would have
enabled you to generate this profit? (You may ignore brokerage costs.)
(a) Selling 1 June XYZ futures contract at 3600
(b) Buying 1 June XYZ futures contract at 3600
(c) Buying 1 June XYZ futures contract at 3200
(d) Selling 1 June XYZ futures contract at 3200

3. A calendar spread contract in index futures attracts ___________.

(a) Same margin as sum of two independent legs of futures contract
(b) Lower margin than sum of two independent legs of futures contract
(c) Higher margin than sum of two independent legs of futures contract
(d) No margin need to be paid for calendar spread positions

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

5. When the near leg of the calendar spread transaction on index futures expires, the
farther leg becomes a regular open position.
(a) True
(b) False

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