Unit 2: Stock, Commodity & Currency Futures

1. Introduction to Futures Contracts

A futures contract is a standardized agreement traded on an exchange to buy or sell an asset at a

predetermined price on a specified future date. Unlike forward contracts, futures are standardized
and regulated, reducing counterparty risk.

Key Features:

• Standardization: Contract terms (quantity, quality, delivery date) are standardized.

• Exchange-Traded: Traded on organized exchanges like NSE, BSE, MCX.

• Margin Requirements: Both parties must deposit an initial margin.

• Mark-to-Market: Daily settlement of gains and losses.

• Clearinghouse Involvement: Acts as an intermediary to guarantee contract performance.

Example: An investor buys a Nifty 50 futures contract expiring in one month. If the Nifty index rises,
the value of the futures contract increases, leading to a profit for the investor.

2. Stock Futures

Definition: Stock futures are futures contracts where the underlying asset is an individual stock.

Characteristics:

• Underlying Asset: Individual company shares.

• Contract Size: Defined by the exchange; for example, 100 shares per contract.

• Settlement: Typically cash-settled in India.

• Liquidity: Varies based on the stock's trading volume.

Use Cases:

• Hedging: Investors can hedge against price movements in specific stocks.

• Speculation: Traders can speculate on the price movement of individual stocks.

Example: An investor anticipates that Reliance Industries' stock price will rise. They buy a futures
contract for Reliance Industries. If the stock price increases, the investor profits from the futures
position.

3. Commodity Futures

Definition: Commodity futures are contracts to buy or sell a specific quantity of a commodity at a
predetermined price on a future date.

Types of Commodities:

• Agricultural: Wheat, rice, cotton.

 • Metals: Gold, silver, copper.

• Energy: Crude oil, natural gas.

Key Features:

• Standardization: Contracts specify quantity, quality, and delivery location.

• Delivery Mechanism: Can be cash-settled or involve physical delivery.

• Trading Platforms: MCX (Multi Commodity Exchange), NCDEX (National Commodity &
Derivatives Exchange).

Use Cases:

• Hedging: Farmers and producers hedge against price fluctuations.

• Speculation: Traders profit from anticipated price movements.

• Arbitrage: Exploiting price differences between markets.

Example: A farmer expects the price of wheat to decline by harvest time. They sell wheat futures
contracts to lock in the current price, hedging against potential losses.

4. Currency Futures

Definition: Currency futures are contracts to exchange a specific amount of one currency for another
at a future date, at a predetermined rate.

Commonly Traded Currency Pairs in India:

• USD/INR

• EUR/INR

• GBP/INR

• JPY/INR

Key Features:

• Standardization: Contracts specify the amount, maturity date, and tick size.

• Trading Platforms: NSE, BSE, MSEI.

• Settlement: Typically cash-settled in INR.

• Regulation: Governed by SEBI and RBI guidelines.

Use Cases:

• Hedging: Importers and exporters hedge against currency risk.

• Speculation: Traders anticipate currency movements.

• Arbitrage: Exploiting differences between spot and futures rates.

Example: An Indian importer expects the USD to appreciate against the INR. To hedge, they buy
USD/INR futures contracts. If the USD strengthens, the gains from the futures position offset the
higher cost of imports.

5. Pricing of Futures Contracts

The price of a futures contract is influenced by the spot price of the underlying asset and the cost of
carry.

Cost of Carry Model:

Futures Price=Spot Price+Cost of Carry\text{Futures Price} = \text{Spot Price} + \text{Cost of
Carry}Futures Price=Spot Price+Cost of Carry

Cost of Carry Components:

• Interest Rates: Cost of financing the position.

• Storage Costs: Applicable for commodities.

• Dividends: Expected dividends for stock futures.

• Convenience Yield: Non-monetary benefits of holding the physical asset.

Example: If the spot price of gold is ₹50,000 per 10 grams, and the cost of carry is ₹500, the futures
price would be ₹50,500.

6. Margin Requirements and Mark-to-Market

Initial Margin: The upfront payment required to enter a futures position, acting as a security against
potential losses.

Maintenance Margin: The minimum account balance that must be maintained. If the account falls
below this level, a margin call is issued.

Mark-to-Market (MTM): Daily settlement process where gains and losses are calculated based on
the day's closing price, and accounts are adjusted accordingly.

Example: An investor holds a futures contract. If the market moves against their position, and the
account balance falls below the maintenance margin, they must deposit additional funds to maintain
the position.

7. Hedging Strategies Using Futures

Hedging involves taking a position in the futures market to offset potential losses in the spot market.

Stock Futures Hedging:

• Portfolio Hedging: Using index futures to hedge a diversified equity portfolio.

• Single Stock Hedging: Using stock futures to hedge exposure to a particular stock.

Commodity Futures Hedging:

 • Producer Hedging: Farmers sell futures contracts to lock in prices.

• Consumer Hedging: Manufacturers buy futures contracts to secure input costs.

Currency Futures Hedging:

• Importers: Buy currency futures to hedge against currency appreciation.

• Exporters: Sell currency futures to hedge against currency depreciation.

Example: An exporter expecting to receive USD in three months can sell USD/INR futures to lock in
the exchange rate, mitigating the risk of INR appreciation.

8. Speculation and Arbitrage in Futures Markets

Speculation: Involves taking positions in futures contracts to profit from expected price movements.

Arbitrage: Exploiting price discrepancies between different markets or instruments to earn risk-free
profits.

Types of Arbitrage:

• Cash-and-Carry Arbitrage: Buying the asset in the spot market and selling futures when
futures are overpriced.

• Reverse Cash-and-Carry Arbitrage: Selling the asset in the spot market and buying futures
when futures are underpriced.

Example: If gold is priced at ₹50,000 in the spot market and ₹51,000 in the futures market, an
arbitrageur can buy gold in the spot market and sell futures contracts, profiting from the price
difference.

9. Regulatory Framework in India

Regulatory Bodies:

• SEBI (Securities and Exchange Board of India): Regulates securities and derivatives markets.

• RBI (Reserve Bank of India): Regulates currency derivatives and monetary policy.

• FMC (Forward Markets Commission): Merged with SEBI in 2015; previously regulated
commodity markets.

Key Regulations:

• Eligibility Criteria: Participants must meet certain criteria to trade in derivatives.

• Position Limits: Restrictions on the maximum number of contracts a participant can hold.

• Disclosure Requirements: Mandatory reporting and transparency norms.

• Risk Management: Exchanges must have robust risk management systems in place.

Example: SEBI mandates that all derivative contracts must be cash-settled unless specified
otherwise, ensuring standardized settlement procedures.
10. Recent Developments in Indian Futures Markets

• Introduction of Weekly Options: Enhances flexibility for traders.

• Launch of New Commodity Contracts: Broadens the range of tradable commodities.

• Growth in Retail Participation: Increased awareness and accessibility have led to higher
retail involvement.

• Technological Advancements: Implementation of sophisticated trading platforms and risk

management tools.

• Regulatory Enhancements: SEBI's continuous efforts to strengthen market integrity and

investor protection.

Conclusion

Futures contracts serve as vital instruments in financial markets, enabling participants to hedge risks,
speculate on price movements, and engage in arbitrage opportunities. Understanding the mechanics,
applications, and regulatory environment of stock, commodity, and currency futures is essential for
market participants. As the Indian derivatives market continues to evolve, staying informed about
developments and adhering to regulatory guidelines will be crucial for effective participation.