University of Calicut

1. Futures and Forwards
Financial Derivatives 3

2. • Spot contract:A contract of buying or selling a commodity,
security or currency for immediate settlement (payment and
delivery) on the spot date.
• Spot date: The spot date refers to the day when
a spot transaction is typically settled, meaning when the funds
involved in the transaction are transferred. The spot date is
calculated from the horizon, which is the date when the
transaction is initiated.
• Spot price : Spot price refers to the current price of a security
at which it can be bought/ sold at a particular place and time.
• Spot market: The spot market is where financial instruments,
such as commodities, currencies and securities, are traded for
immediate delivery.

6. Features of forwards
• Bilateral contracts
• Customised
• OTC
• Settlement  Cash or Delivery of asset
• Zero sum game
• Tool for Hedging

7. Difference between Spot contract and
Forward contract
Particulars Spot Forward
Performance of contract Immediate Future date
Counter party risk No Yes
Familiarity between parties Not always Always
Hedging and speculation Not possible Possible

8. Advantages
1. To hedge the risk in future
2. Tailor-made
3. Flexible
4. No initial movement is required
Limitations
1. OTC  No ready liquidity
2. Lack of centralised trading
3. Counter-party or default risk
4. Difficulty in finding matching parties
5. Difficult to offset

9. • Futures are derivative financial contracts that obligate the parties to
transact an asset at a predetermined future date and price. Here, the
buyer must purchase or the seller must sell the underlying asset at
the set price, regardless of the current market price at the expiration
date.
• Underlying assets include physical commodities or other financial
instruments. Futures contracts detail the quantity of the underlying
asset and are standardized to facilitate trading on a futures exchange.
Futures can be used for hedging or trade speculation.
• Exchanges : NCDEX, MCX, NSE, BSE …

10. Features
• Traded on exchange
• Standardised
• Clearing house
• Elimination of default risk
• Margin System
• Cash settled

11. • Advantages
1. No counter party risk
2. More liquid
3. Standardised contracts
4. Transfer risk
5. Hedging & speculation
6. Less transaction cost
• Disadvantages
1. Problem to trader
2. Perfect hedging may be impossible
3. More margins
4. Create favourable price movements

12. TERMINOLOGY -Futures
1. Underlying asset
• Underlying asset is an investment term that refers to the
real financial asset or security that a financial derivative is
based on.
• Underlying assets include stocks, bonds, commodities,
interest rates, market indexes, and currencies.
• Different classes of underlying assets and their financial
derivatives are subject to different kinds of investment risk.

13. 2. Each futures contract specifies the quantity of the product
delivered for a single contract, also known as contract size. For
example: 5,000 bushels of corn, 1,000 barrels of crude oil or
Treasury bonds with a face value of $100,000 are all contract
sizes as defined in the futures contract specification.
• The prices of stock futures and currency futures may differ
from prices of their underlying assets and can be either higher
or lower. These prices reflect the market sentiment and a
general attitude of traders and investors toward a specific
stock or currency. Price quotation – quantity specific
• Tick size is the minimum price change between different bid
and offer prices of an asset traded on an exchange platform. It
is the minimum price difference that must exist at all times
between consecutive bid and offer prices.

14. • Price limits are the maximum price range permitted for a futures
contract in each trading session. These price limits are
measured in ticks and vary from product to product. When
markets hit the price limit, different actions occur depending on
the product being traded.
• Position Limit - The maximum number of speculative futures
contracts one can hold as determined by the Commodity
Futures Trading Commission and/or the exchange upon which
the contract is traded. Also referred to as trading limit.
• Spot price refers to the current price of a security at which it
can be bought/ sold at a particular place and time.
• Futures Price – Price in which a future contract is traded in a
futures market

15. • The date upon which a futures contract expires is known as its
expiration date.
• Basis - In the futures market, basis represents the difference
between the cash price of the commodity and the futures price
of that commodity. Normal- Future price exceeds spot price
• The cost of carry or carrying charge is cost of storing a physical
commodity, such as grain or metals, over a period of time. The
carrying charge includes insurance, storage and interest on the
invested funds as well as other incidental costs.
• Open interest is the total number of futures contracts held by
market participants at the end of the trading day. It is used as
an indicator to determine market sentiment and the strength
behind price trends.

16. • If an investor has long positions, it means that the investor
has bought and owns those shares of stocks. By contrast, if the
investor has short positions, it means that the investor owes
those stocks to someone, but does not actually own them yet.
• An open position in investing is any established or entered trade
that has yet to close with an opposing trade –
outstanding/unsettled derivative contracts

17. Types of futures
• Commodity
• Currency
• Stock
• Interest rate
• Index

18. Trading Process
1. Select a broker/brokerage house registered with commodity
exchange
2. Open a trading account
3. Choose a future(type)
4. Choose a contract
5. Select strategy
6. Purchase futures contract

19. Trading Mechanism
1. Placing an order
2. Role of clearing house
3. Daily settlement
• Initial margin
• Marking – to-market
• Maintenance margin
• Variation margin
1. Settlement