Uses of futures

Futures contracts are standardized agreements to buy or sell an underlying asset at a predetermined price on a future date. Because they are traded on exchanges such as NSE and BSE, they enjoy high liquidity, transparent pricing and daily mark‑to‑market settlement as mandated by SEBI.

The standardisation means each contract has a fixed lot size, expiry cycle and tick size. For equity index futures, the lot size is set by the exchange (e.g., 75 shares for NIFTY), which simplifies margin calculations and risk monitoring for participants.

For the NISM exam, you must recognise that futures are not merely speculative tools; they serve three core functions that shape market dynamics and risk‑management strategies.

The first and most widely taught use is hedging. Commercial investors, portfolio managers and exporters use futures to lock in prices and protect against adverse movements in the underlying asset, thereby stabilising cash flows.

The second use is speculation. Individual traders and proprietary desks take directional bets on price movements, aiming to profit from short‑term volatility without intending to take delivery of the underlying.

The third use is arbitrage. Arbitrageurs exploit price differentials between the spot market, futures market, or between futures of different expiries, earning a risk‑free return after accounting for transaction costs and margin requirements.

Hedging involves taking a position in a futures contract that offsets the price risk of an existing exposure. For example, an Indian exporter expecting to receive USD in three months can sell USD‑INR futures to lock the rupee value of that receipt.

The effectiveness of a hedge depends on the correlation between the spot and futures price, the contract size, and the timing of the hedge relative to the exposure. SEBI requires that margin be maintained on a daily basis, so the hedger must have sufficient liquid resources to meet potential margin calls.

In the exam, you will often be asked to identify the correct hedge ratio or to decide whether a futures contract is appropriate for a given exposure. Remember that a perfect hedge eliminates price risk but does not eliminate basis risk, which is the difference between the spot and futures price at expiry.

Speculators aim to profit from anticipated price movements without any intention of taking delivery. Because futures require only a margin deposit (typically 10‑15% of contract value), they provide high leverage, magnifying both gains and losses.

In India, retail investors can trade equity‑index futures through their demat account, but they must comply with SEBI’s position limits and margin maintenance rules. The exam frequently tests knowledge of margin calculations and the impact of leverage on return volatility.

A common trap is to assume that a speculative profit equals the price change multiplied by the contract size; forgetting the effect of daily mark‑to‑market and margin calls can lead to incorrect answer choices.

Arbitrage exploits price inconsistencies between related markets. In the Indian context, a cash‑and‑carry arbitrage might involve buying the underlying stock, selling the corresponding futures, and holding the position until expiry, locking in a risk‑free return after accounting for financing costs and transaction fees.

Regulatory rules require that arbitrageurs maintain sufficient margin and adhere to the "no‑position‑limit" exemption for bona‑fide arbitrage. The NISM exam may present a scenario where the futures price is higher than the fair value calculated using the cost‑of‑carry model; you must identify the arbitrage strategy and compute the net profit.

Remember that arbitrage profits are generally modest, and the key to answering exam questions is to recognise the direction of the trade (long spot, short futures or vice‑versa) and to include financing cost in the calculation.

SEBI mandates that all futures contracts be cleared through a central clearing house, which guarantees settlement and reduces counter‑party risk. Participants must maintain the initial margin (set by the exchange) and a variation margin that reflects daily price changes.

Margin rates differ across asset classes; equity‑index futures typically require a lower margin than commodity futures because of higher liquidity. The exchange publishes daily margin updates, and brokers must convey these to clients.

For the exam, be aware of the difference between "initial margin" (the amount posted at trade entry) and "maintenance margin" (the minimum balance that must be kept). Failure to meet the maintenance margin triggers a margin call, and the position may be liquidated by the clearing house.

Memorise the three core uses – hedging, speculation and arbitrage – and associate each with a typical Indian market participant. This mapping helps you eliminate wrong answer choices quickly.

Practice the payoff formula (F_T - F_0) × Q and be comfortable substituting contract size, as many scenario questions require a numeric profit or loss calculation.

Finally, always read the question stem for clues about margin requirements, SEBI limits or the time horizon. These details often decide whether the correct answer relates to hedging effectiveness, speculative leverage or arbitrage feasibility.