Chapter 3 — Introduction to Forwards and Futures
Think of this chapter in 5 parts:
Part 1 → Forwards | Part 2 → Futures & Terminology | Part 3 → Payoff Charts | Part 4
→ Pricing | Part 5 → Uses
Part 1 — Forward Contracts
You already know the definition from Chapter 1. Chapter 3 goes deeper — it explains how
they work with a live example, and crucially, why they are problematic (which is what led
to futures being invented).
The Workbook Example: On May 11, 2024, gold spot price = ₹62,130 per 10 grams. You
don't want delivery today — you want it after 1 month. The goldsmith quotes ₹62,337 for
delivery after 1 month. You agree. No money changes hands today. After 1 month you pay
₹62,337 and take gold — regardless of what the market price is then.
If gold rises to ₹62,700 → you gain ₹363 (buy at ₹62,337, sell in market at ₹62,700)
If gold falls to ₹62,100 → you lose ₹237 (forced to buy at ₹62,337, market is only
₹62,100)
The two killer limitations of forwards — and why futures were born:
Limitation What it means
Forwards are tailor-made OTC contracts. No one else wants your specific
Liquidity Risk
contract. You cannot exit before maturity — you are stuck.
Counterparty If rice is at ₹50 but you agreed to sell at ₹40, the seller may simply
Risk default. No one enforces the contract.
Futures were created specifically to solve both these problems.
Part 2 — Futures Contracts & Key Terminology
Futures = Forwards traded on an exchange, standardized, with the clearing corporation
guaranteeing settlement.
Essential terminology — all directly tested:
Part 3 — Payoff Charts
This is one of those things that looks hard but becomes completely mechanical once you get
the logic. There are only 2 payoff charts for futures — long and short.
The rule is simple: Payoff = Current Market Price at Expiry − Futures Entry Price (for long).
CHART
The one line to memorize: Long futures = profit when price rises. Short futures = profit
when price falls. Both have unlimited profit AND unlimited loss potential — this is what
makes futures "linear payoffs."
Part 4 — Futures Pricing
Two models. The Cost of Carry model is the one you must know for calculations.
The Core Formula:
F = S × (1 + r − q)^T
Where: F = Fair Futures Price, S = Spot Price, r = Cost of financing (interest rate), q = Return
from holding asset (dividend yield), T = Time to expiry in years
Continuous compounding version: F = S × e^(r−q)×T
Workbook example worked out:
Index at 17,500, financing cost = 12% p.a., dividend yield = 4% p.a., time = 90 days
F = 17,500 × (1 + 0.12 − 0.04)^(90/365) = 17,500 × (1.08)^0.2466 = ₹17,835.26
The No-Arbitrage logic behind this formula: If futures price > fair price → Cash and Carry
Arbitrage (buy spot, sell futures). If futures price < fair price → Reverse Cash and Carry (sell
spot, buy futures). These actions keep futures price anchored near fair price.
Two important pricing market states:
State What it means Sign
Contango Futures price > Spot price (normal for equities) Positive carry
Backwardation Futures price < Spot price (convenience yield dominates) Negative carry
Convenience Yield — a concept for commodities only (not equities). During a
crisis/scarcity, people derive intangible value from holding a commodity physically. This can
push spot price above futures price (backwardation), and makes the Cost of Carry model
break down for such assets.
Assumptions of Cost of Carry model (direct exam question):
Asset is available in abundance in cash market
Demand and supply are NOT seasonal
Asset can be held/stored easily
Asset can be sold short
No transaction costs, no taxes, no margin requirements
Part 5 — Uses of Futures (Section 3.9)
Three uses — hedging, speculation, arbitrage — you know these from Chapter 1. Chapter 3
adds specific examples:
Hedging example: An investor holds a diversified equity portfolio worth ₹50 lakh. Worried
about a market correction, she sells Nifty index futures. If the market falls, her futures profit
offsets the portfolio loss.
Speculation example: Trader believes Infosys will rise after earnings. Instead of buying
shares (which requires full capital), he buys Infosys futures (pays only margin — leverage). If
right, profit is amplified. If wrong, loss is also amplified — "leverage is a double-edged
sword."
Arbitrage example (workbook): Stock spot = ₹100, May futures = ₹110, lot = 50.
Buy at ₹100 in cash market + sell at ₹110 in futures simultaneously → lock ₹10/share
profit
Whatever the expiry price (₹108 or ₹95), total profit always = ₹10/share = ₹500/lot
Price Discovery & Convergence — one last critical point: at expiry, futures price and spot
price must always converge to the same value. This is why final settlement is at the closing
spot price. The futures market acts as a price discovery mechanism — today's futures price =
market's expectation of spot price at expiry.
Chapter 3 in One Paragraph
A forward is a private locked-in deal with liquidity and counterparty risk. Futures solve both
by being standardized, exchange-traded, and cleared by a clearing corporation. Key contract
specs are lot size, expiry (last Tuesday for NSE), tick size, and daily MTM settlement. Basis
(spot − futures) converges to zero at expiry. Fair futures price = Spot + Cost of Carry −
Income. Payoffs are linear — long profits when price rises, short profits when price falls —
both with unlimited potential. Futures are used for hedging, speculation (with leverage), and
arbitrage (locking risk-free profit from mispricing).