CH.

FUTURES
 MEANING
• A Future Contract is a standardized contract
between a clearing house of a derivative exchange
& a buyer or seller of underlying assets to buy or
sell, exchange decided quantity of underlying asset
on a specified future date at a pre-determined
price.
• Thus,
 It is a contract between exchange clearing house &
buyer & seller of underlying asset.
 The quantity under the contract is standardized &
decided by the exchange.
 The specified future date is also standardized &
decided by the exchange.

• The buyer & the seller of the underlying assets

under the future contract has to pay a token
payment called margin money at the time of
entering into the contract.

• Subsequently, they have to pay mark-to-market

margin & any other margin as specified by the
exchange.
 TERMINOLOGIES
• Transaction/Contract Date: Contract date is the
date on which buyer/seller agree to enter into
transaction with derivatives exchange to buy/sell
the underlying asset.
• Settlement Date/Value Date: The day on which
transaction is settled either by offsetting it in cash
or by giving the delivery of the underling asset at
the price agreed on transaction/contract date.
• Ready Contract: In case of ready contract, the
contract date & the value date in the same i.e. the
delivery of the underlying asset is immediate.
• Spot Transaction: In this case, the value date is two
days after the contract date (T+2) i.e. the delivery of
the underlying assets or offsetting in cash is done 2
days after the contract date.

• Spot Price: The price of an underlying asset that is

quoted for the immediate delivery of the underlying
asset is known as spot price. It is also referred to as
cash price. Spot prices are quoted on the cash/spot
segment of exchange.
• Forward Price/Futures Price: The price mutually
agreed between the parties to the contract at the
time of entering into the contract for the delivery of
the underlying asset at a future specified date is
referred to as futures price.
• Expiration Date: Expiration date is the date on
which Forward, Futures & Options are settled.
While in case of options contract expiration date is
simply the last date by which option can be
exercised.
• Basis: Basis is the difference between the spot price
& the futures price of the underlying asset.
• Cost of Carry: It is the cost of holding the underlying
asset over a period of time. It includes interest on
invested fund, storage cost & other identical costs.
It is also referred to as carrying charges.

• Long Futures Contract: A contract to buy the

underlying asset.

• Short Futures Contract: A contract to sell the

underlying asset.
 PRICING OF FUTURES CONTRACT
• Underlying asset may or may not yield any income
till the delivery or settlement date.
• Future price of underlying assets which may not
yield any income till settlement date are priced
differently than the underlying assets which yield
income before the settlement date.
• In other words, Future price of a share of Company
A which is not likely to declare any dividend till the
settlement date will be priced differently from the
futures price of Company B which is likely to declare
dividend before the settlement date.
• Thus, pricing of futures will be based on the
likeliness of underlying asset yielding income as
under:

 Underlying asset not paying any income before

delivery or settlement date

 Underlying asset paying income

 A. UNDERLYING ASSET NOT PAYING ANY
INCOME BEFORE SETTLEMENT DATE

• Fixing the Base price & Closing Price

• Cost of Carry Model of Futures Pricing

 Fixing the Base Price & Closing Price
• Initially exchange decides the ‘Base Price’ of a
futures contract at the time of entering the
contract.

• Base Price is a notional price based on the spot

price of the underlying asset on the previous day &
a notional carrying cost.

• On subsequent days the official closing price of the

contract during the previous trading day is taken as
its base price.
• If no trade takes place on the day of the launch of
contract, then exchange can change the base price
for the next trading session if the spot price is
volatile & fluctuates during the previous trading
day.

• After the end of a trading session, the system of the

exchange calculates the ‘closing price’ of each &
every contract traded on the system.

• The logic in general for he calculation of closing

price is as follows:
 Closing price is equal to weighted average price of
all the trades executed during the last 30 minutes of
a trading session.
 If the number of trades during the last 30 minutes is
less than 10, then it is based on the weighted
average price of the last 10 trades executed during
the day.
 If the number of trades done during the day is less
than 10, then it is taken as the weighted average of
all trades executed during the day.
 If no trades have been executed in a contract on a
day, then the official closing price of the previous
trading session is taken as the official closing price.
Cost of Carry Model of Futures Pricing
• Cost of Carry, also known as carrying charges, is an
important element in determining pricing
relationship between spot & futures prices as well
as between prices of futures contract of different
expiry months.

• According to Cost of Carry Model, futures prices

depends on the spot price of the underlying asset &
the cost of carrying the underlying asset from the
date of spot price to the date of settlement of the
contract.
 B. UNDERLYING ASSET PAYING INCOME

• Continuous Income Paying Investment Asset

• Discreet Income Paying Investment Asset.

 Continuous Income Paying Investment
Asset
• Investment assets like Money Market Instruments
such as T-Bills, pays income at a constant rate
continuously throughout the futures contract
period.

• The income distributed on such investment assets

are cash inflows which should be taken into account
while computing theoretical futures price.
Discreet Income Paying Investment Assets
• Investment assets like equity shares, pay dividend
at discreet points in time over the life of the asset,
usually after the end of the financial year.
• The benefits of dividend do not accrue to the buyer
of the futures contract.
• The benefit accrues to the registered owner of the
equity shares.
• The present value of such benefit should be
deducted from the futures price.
• Basis – The difference between the futures price &
the spot price is called as ‘basis’. The basis
represents the cost of carry for the unexpired
period of the contract. The basis reduces as time
elapses & becomes zero on maturity. This is
because, the cost of carry is zero on maturity

• Normal Market – In normal markets futures price

exceeds spot price

• Inverted Market – In inverted market the futures

price is less than the spot price
 RELATIONSHIP BETWEEN FUTURES
PRICE & EXPECTED SPOT PRICE
• According to the cost of carry model, the spot price
& futures price converge on maturity, irrespective
of market being normal or inverted.

• This can best be explained with the help of the

theories:
 Backwardian Theory
 Contango Theory
 Expectancy Theory of Future Pricing
Backwardian Theory
• Lord Keynes, a famous economist propounded the
Backwardian theory. A situation wherein the spot
price is greater than the futures price, is referred to
as Backwardation. This happens in case of
underlying asset having large convenience yield.
The benefit that the holder gets for holding these
assets is known as convenience, & when this
convenience is quantified in percentage terms, it is
called as convenience yield. It is denoted by letter y.
Thus, in Backwardian theory, y > r
Contango Theory
• The Keynes Backwardian theory is primarily based
on the assumption that hedgers have net short
position & speculators have net long position, only
then Backwardian holds. Whereas, contango
assumes the opposite of Keynes theory i.e. hedgers
have net long position & speculators have net short
position, only then contango holds. A relationship
where futures price exceeds the spot price is known
as Contango. This happens because of the market
inefficiencies about which the speculators have
better knowledge & understanding.
• All non-income earning financial assets are always
in Contango. As long as interest rates are positive,
the futures price will exceed spot price. Only in case
of negative interest rates, which is so rare, that the
relationship will not be contango.
• Thus, the degree of Backwardian or Contango
indicates the nature of market, the magnitude of
trade & the attempts to manipulate the markets.
Backwardian & Contango can be observed between
spot & futures as well as between futures having
different maturities i.e. short maturity futures &
long maturity futures.
Expectancy Theory
• The expectancy theory of futures pricing states that
futures price is reflection of future spot price.
According to expectancy theory, the relationship is
between the futures price & future spot price & not
current spot price. The expected demand & supply
situation & the perceived riskiness of demand-
supply position establish the futures spot price &
not the cost of carry alone. Thus, the expected rate
of return of market participants on the financial
assets shall comprise of the risk-free interest rates
& risk premium (p) to compensate for the riskiness
of the asset
• The degree of risk premium depends on the
participant’s expectations about the direction of
futures price on account of demand & supply.
Therefore, it can be said that the difference
between the expected spot price at maturity & the
futures price consists of risk premium.
 STOCK INDEX FUTURES
• Stock index futures are futures contracts on stock
indices
• The underlying asset is a specified stock index
• Stock index futures may be described as ‘a
commitment to buy or sell at a future date, a
portfolio of stocks of which index is composed of
• Stock index futures are settled in cash by taking an
off-setting position, since stock index on itself is not
an asset
• Stock index is a market performance indicator that
captures the price movements for the market as a
whole based on the stocks included in different
proportion for the composition of index
• It would be impractical for the trader to deliver
stock in the same proportion as they are included in
the index
• The Kansas City Board of Trade was the first to
introduce stock index futures on 24th February 1982
based on Value Line Composite Index
• Later other exchanges of the world also introduced
stock index futures on various indices
• Chicago Mercantile Exchange’s S&P 500 Futures, a
stock index futures on S&P 500 index, is most
actively traded stock index futures
• Stock index futures are successful as they help in
managing large portfolio of stocks
• In India, the Securities Contract Regulation Act
(SCRA) was amended in 1999 to include derivatives
within the definition of ‘securities’.
• In May 2000, SEBI granted final approval for trading
in derivatives.
• Accordingly, SEBI approved trading in index futures
contracts based on S&P CNX Nifty & BSE Sensex
• On 9th June, 2000, trading on BSE Sensex futures
commenced on BSE, while on 12th June, 2000 the
futures trading on NSE commenced with S&P CNX
Nifty Index futures
• Subsequently, several other stock index futures
based on variety of stock indices has been
introduced in India
• Till date NSE S&P CNX Nifty is the most popular
stock index futures in India
• The popularity of stock index futures in India can be
attributed to following factors
 Individual stock prices are prone to manipulation by
some vested players, whereas, scope for manipulation
of stock index is less
 Cash market trades require full payment, whereas,
stock index futures require lower capital adequacy &
margins
 Brokerage on stock index futures are lower than that on
cash segment
 Impact on cost of stock index futures are much lower
compared to that of individual stocks
 No need for physically holding the stock or physical
delivery, since settlement is in cash. Short selling is
possible, which is not possible in case of individual stock
Stock Index Futures Terminology
• Spot Price: Spot price is a price at which the
underlying asset is trading in the spot market or
cash segment of the exchange
• Future Price: It is the price at which futures
contract trades in the futures market or derivatives
segment of the exchange
• Contract Cycle: It is a period over which a futures
contract trades. Currently on BSE & NSE there are
three contract cycles, namely, one month, two
months & three months which expire on the last
Thursday of the ending month.
• Expiry Date: This is the last day on which the futures
contract will be traded & thereafter it will cease to
exist. The expiry date is specified in the future
contract.
• Contract Size: It is also referred to as lot size.
Contract size denoted the quantity of underlying
asset required to be delivered under one futures
contract.
• Basis: Basis is the difference between spot price &
futures price. Each futures contract for each delivery
month will have different basis. In normal market
futures price exceeds spot price, thus basis will be
positive & vice versa in case of inverted market.
• Cost of Carry: It is the cost of holding the underlying
asset over a period of time. It includes interest on
invested funds, storage cost & other identical cost.
It is also referred to as carrying charges.

• Initial Margin: It is the amount to be deposited by

the market participants in their margin account
with clearing house before they can place order to
buy or sell futures contracts. This must be
maintained throughout the time their position is
open & is returnable to final settlement of the
contract.
• Mark-to-Market Margin: At the end of each trading
day notional loss or gain on the futures contract is
calculated to reflect the investor’s loss or gain. This
loss or gain is adjusted in the margin account of the
investor. This process is referred to marking-to-
market.
• Maintenance Margin: This is the minimum level of
margin that needs to be maintained in the margin
account. Maintenance margin are usually lower
than initial margin. This margin makes sure that the
balance in the margin account never becomes
negative. If it happens, the investor receives a
margin call to restore the balance.
Features & Specifications
• Contract Size: The minimum contract size at the
time of introduction of futures contract should be
close to Rs. 1,00,000 for mini derivative contract on
index & close to Rs. 2,00,000 for all other stock
index futures

• Contract Multiplier: The contract multiplier should

be such that it comply with minimum contract size
requirement. If Sensex value is 40,000 then the
multiplier for Sensex Mini Futures will be 2.5
(1,00,000/40,000)
• Contract Period/Cycle: At any point in time three
monthly contract are available. The near month,
the next month & the far month.

• Tick Size: It is the minimum change that is

permitted in futures price quotation. It is fixed at
0.05 index points for both BSE & NSE

• Maturity/Expiry: Each contract expires on last

Thursday of the delivery month. On next Friday new
series come into existence
• Settlement: Since index is non-deliverable the index
futures are settled in cash. The obligations under
the futures contract can be liquidated by entering
into contract opposite to the original contract
before the maturity. If not closed, it automatically is
closed on the last trading day at a price determined
by spot value of index
• Margins: Initial margin as determined by exchange,
which is certain percentage of contract value, is
required to be deposited at the time of executing
the index futures contract for both sell as well as
buy contracts. Besides initial margin, mark-to-
market margin is also required
Difference in Theoretical Futures Price
& Actual Futures Price
• The transaction cost in the form of commission, bid-
ask spreads, etc which are not considered while
calculating fair value of futures. These costs are not
usually constant. They vary from time to time &
from contract to contract. These costs get reflected
in the actual futures price but not in theoretical
price due to its variable nature
• Income yield vary over the contract period. This
variation influences the actual futures prices & it
may be different from actual theoretical futures
price
• The underlying asset in stock index futures contract
is conceptual & not real. It would be practically
difficult to go long or short on large number of
stocks included in the index in exactly same
proportion as index. This impracticality would tend
to make actual futures price different from
theoretical futures price.

• Cost of carry model assumes uniform interest rates

across all market participants. However, in reality
the interest cost may be different for different
investor. This difference results in the differences in
actual & theoretical futures prices.
• Depending on the volatility in market prices & index
exchange insists on different types of margins such
as initial margin, mark-to-market margin etc. on an
ongoing basis during the futures contract period.
These margin requirements tend to make actual
futures price different from theoretical futures
price.

• The demand & supply conditions of underlying at

present & expectation of future demand & supply
or perception of future demand & supply influences
actual futures prices. The cost of carry model does
not consider any of the above demand & supply.
 STOCK FUTURES
• Stock futures are financial derivatives contract where
the underlying asset is an individual stock
• Like stock index futures contract, stock futures are
also standardized contract traded on derivatives
exchange or derivatives segment of stock exchange
• Underlying in case of stock index futures is
conceptual whereas, underlying in case of stock
futures is real & therefore, delivery of underlying is
possible
• However, in India, for sake of uniformity stock futures
are currently cash settled & delivery is not required.
Lack of Interest in Stock Futures
• Individual stock prices are more volatile than the Stock
index futures
• Individual stocks are more prone to manipulation than the
stock index
• Higher volatility in individual stock prices prompts
exchanges to fix higher margins for stock futures. Thus,
cost of hedging with stock index futures is lower than that
of individual stock futures
• Institutional investors have experienced that passive
portfolio strategy have yielded better returns than active
portfolio strategy. Stock index futures are better tool of
passive portfolio strategy compared to individual stock
futures