Futures contracts

A futures contract is a legally binding agreement, traded on a recognized exchange, to buy or sell a specified quantity of an underlying asset at a fixed price on a predetermined future date.

Unlike forwards, futures are standardized – the exchange defines the contract size, tick size, expiry cycle and the settlement method. This standardisation ensures high liquidity and enables participants to enter or exit positions with ease.

For the NISM exam, remember that futures are exchange‑traded and marked‑to‑market daily. Questions often test whether you can identify these traits when presented with a scenario.

• Exchange‑traded → clearing house guarantees performance.
• Standardized → no need for individual negotiation.

Futures contracts possess several distinctive features: a fixed contract size (e.g., 75 NIFTY shares per lot), a minimum price movement called tick size, and a set of expiry dates (typically the last Thursday of the contract month).

Another hallmark is the daily settlement process, also known as mark‑to‑market. At the end of each trading day, gains and losses are realized, and the trader’s margin account is adjusted accordingly.

Exam‑wise, you will often be asked to calculate the amount of variation margin required or to identify the correct expiry cycle for a given index future.

• Standardized contract size simplifies price quoting.
• Daily settlement reduces counter‑party risk.

Each futures contract is defined by a set of specifications published by the exchange. The most important elements are:

Lot size – the number of units of the underlying per contract (e.g., 75 shares for NIFTY). Tick size – the smallest price increment (e.g., ₹0.05 for NIFTY). Tick value – monetary value of one tick (lot size × tick size).

Initial margin – the collateral required to open a position, usually a percentage of the contract value. Maintenance margin – the minimum balance that must be maintained; falling below triggers a margin call.

• All specifications are publicly available on NSE/BSE websites.
• Understanding these numbers is essential for margin‑related calculations in the exam.

The theoretical price of a futures contract is derived from the cost‑of‑carry model. The model adds the financing cost, storage cost, and subtracts any convenience yield earned on the underlying asset.

In the Indian context, the risk‑free rate is typically the yield on government securities, while storage cost applies mainly to commodity futures. For equity index futures, storage cost is negligible, but the model still holds.

Exam questions may present spot price, risk‑free rate, storage cost, and convenience yield, asking you to compute the fair futures price using the continuous‑compounding formula.

At the close of each trading day, the exchange calculates the settlement price of the futures contract. The difference between this price and the previous day's settlement price is the variation margin, which is credited or debited to the trader’s margin account.

If the account balance falls below the maintenance margin, the trader receives a margin call and must deposit additional funds (known as the additional margin) to restore the balance to the initial margin level.

This daily cash‑flow mechanism limits credit exposure and is a frequent topic in NISM questions that ask you to compute the net cash flow after a series of price movements.

• Initial margin ≠ premium paid – futures require no upfront premium.
• Variation margin can be positive or negative each day.

Indian equity index futures (e.g., NIFTY, BANKNIFTY) are settled in cash, meaning the final settlement amount is the cash difference between the futures price and the underlying index value on expiry.

Commodity futures, such as gold or crude oil, may be settled physically, where the actual commodity is delivered against the contract. The exchange specifies the delivery point, quality standards, and notice periods.

Exam takers should note the settlement type indicated in the contract specifications, as it determines whether a delivery obligation exists and influences hedging strategies.

• Cash‑settled → no physical delivery, easier for equity index hedgers.
• Physically settled → logistics and storage considerations matter.

SEBI (Securities and Exchange Board of India) regulates all futures trading in the country. Key regulations include mandatory registration of brokers, real‑time reporting of positions, and strict margin norms set by the exchange and the clearing corporation.

The National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) act as the primary platforms, while the Clearing Corporation of India Ltd (CCIL) guarantees settlement and manages the default fund.

For the exam, remember that SEBI’s role is supervisory, whereas the exchange defines contract specifications and the clearing house handles daily settlement and margin enforcement.

• SEBI → overall market integrity and investor protection.
• Exchange → contract design, trading, and price discovery.
• Clearing corporation → settlement guarantee.

Students often err by mixing up the concepts of spot price and futures price. Remember that the futures price incorporates the cost of carry, while the spot price does not.

Another frequent mistake is ignoring the daily settlement effect when calculating profit or loss. The correct approach is to compute the variation margin for each day rather than a single end‑of‑period payoff.

Finally, many overlook the distinction between cash‑settled and physically settled contracts, leading to incorrect answers about delivery obligations or cash flows at expiry.

• Check whether the question specifies cash or physical settlement.
• Always apply the cost‑of‑carry formula when asked for a theoretical futures price.
• Remember margin is collateral, not a premium.