Types of Futures Contract

4.1 What are Commodity Futures?

Futures are standardized financial contracts where two parties agree to buy or sell an asset at a predetermined price on a specified future date. They are traded on organized exchanges and cover a wide range of assets, including commodities, stocks, indices, and currencies. Types of futures include commodity futures (e.g., crude oil, gold), financial futures, equity futures, currency futures, and interest rate futures. Each type serves distinct purposes, such as hedging, speculation, or portfolio diversification, making them versatile instruments in financial markets.

Commodity Futures are standardized contracts to buy or sell a specific quantity of a commodity at a predetermined price on a specified future date. These contracts are traded on organized exchanges such as the Multi Commodity Exchange (MCX) or National Commodity and Derivatives Exchange (NCDEX) , or Chicago Mercantile Exchange (CME) globally. Commodity futures are primarily used by producers, consumers, and traders to hedge against price volatility or speculate on the future price movements of the underlying commodities.

Key Features of Commodity Futures:

1. Underlying Assets: The underlying assets in commodity futures are physical goods or raw materials, categorized into hard commodities (e.g., oil, gold, metals) and soft commodities (e.g., wheat, coffee, cotton, livestock).
2. Contract Specifications: A typical commodity futures contract specifies:

• The commodity type (e.g., crude oil, gold, corn).
• The quantity (e.g., 100 barrels of oil, 1,000 bushels of corn).
• The delivery date (the contract’s maturity date).
• The agreed-upon price (also known as the strike price).

3. Leverage: Futures contracts involve margin trading, where traders only need to deposit a small percentage of the contract value as margin. This allows for leverage but also increases the risk of losses.
4. Settlement:

• Physical Settlement: The commodity is delivered as per the contract terms (more common for commodities like agricultural products or metals).
• Cash Settlement: The contract is settled in cash based on the difference between the contract price and the market price at expiration (more common in financial or index futures).

Types of Commodity Futures:

1. Energy Futures:

• These are based on energy products like crude oil, natural gas, gasoline, and heating oil.
• Example: A contract to buy or sell 1,000 barrels of crude oil at a fixed price for delivery in the future. Energy futures are commonly used by oil producers and refiners to hedge against price fluctuations.

2. Metals Futures:

• These contracts are based on precious metals like gold, silver, and platinum, as well as base metals like copper, aluminium, and zinc.
• Example: A contract for 100 ounces of gold to be delivered in three months. Investors often use gold futures to hedge against inflation or economic uncertainty.

3. Agricultural Futures:

• These futures are based on agricultural commodities like wheat, corn, soybeans, coffee, sugar, and cotton.
• Example: A farmer might sell wheat futures to lock in a price before the harvest, protecting against the risk of falling prices.

4. Livestock Futures:

• These futures involve cattle, hogs, and other livestock products.
• Example: A meat processor might use cattle futures to hedge against fluctuating prices of beef.

Participants in Commodity Futures:

1. Hedgers:

• Producers and consumers of commodities use futures to protect themselves from price volatility. For example, an oil producer might sell crude oil futures to lock in a future price and mitigate the risk of price declines.
• Similarly, a food processing company might buy wheat futures to ensure a stable price for the wheat they need to buy in the future.

2. Speculators:

• Traders who aim to profit from changes in the price of commodities. Speculators do not intend to take delivery of the commodity but instead aim to profit from price movements.
• For example, a trader might buy gold futures if they expect the price of gold to rise in the future.

3. Arbitrageurs:

• These market participants look for price discrepancies between the futures and spot market (the actual market for physical goods) and make trades to profit from these differences.

Uses of Commodity Futures:

1. Hedging Risk: Commodity futures are used to hedge against price fluctuations. For example, airlines may use fuel futures to lock in prices for aviation fuel, while farmers may use crop futures to lock in prices for their crops, thereby stabilizing their income.
2. Speculation: Traders use commodity futures to speculate on the direction of price movements, hoping to profit from changes in commodity prices. Speculators provide liquidity to the market but also increase its volatility.
3. Price Discovery: Futures markets play a critical role in discovering the future price of commodities. The futures price reflects the market’s consensus about what the price of the commodity will be at the contract’s expiration date.
4. Investment: Investors can use commodity futures to diversify their portfolios, especially in times of market uncertainty. Commodities like gold are often seen as a safe haven during economic crises.

Benefits of Commodity Futures:

1. Leverage: Futures contracts allow for the use of margin, meaning investors can control a large amount of the underlying commodity with a relatively small initial investment. This enhances potential returns, but also increases risk.
2. Liquidity: Futures markets are highly liquid, making it easy to enter or exit positions quickly.
3. Transparency: Futures markets are regulated and provide transparent pricing, making it easier for participants to evaluate market conditions.
4. Hedging Against Inflation: Commodity futures, especially in gold and energy, are often used as a hedge against inflation or currency devaluation.

Risks of Commodity Futures:

1. Leverage Risk: While leverage can amplify returns, it also amplifies losses. Small price movements in the underlying commodity can result in significant gains or losses.
2. Market Volatility: Commodities can be highly volatile, with prices influenced by a wide range of factors, including geopolitical events, weather patterns, and economic reports.
3. Delivery Risk: If a contract is settled by physical delivery, there may be complications in receiving or delivering the commodity, especially for smaller investors.

Commodity futures are essential tools for hedging against price volatility, speculating on future price movements, and diversifying investment portfolios. They provide a mechanism for price discovery and ensure liquidity in the markets. However, due to the leverage involved and the potential for high volatility, they also carry significant risks, making them suitable primarily for sophisticated investors or entities with a specific need to manage commodity price exposure.

4.2. What are Equity Futures?

Equity Futures are financial contracts that obligate the buyer to purchase, or the seller to sell, a specific quantity of a stock or stock index at a predetermined price on a future date. Unlike traditional stock trading, where investors buy and sell shares directly, equity futures allow investors to speculate on the future price movements of individual stocks or a stock market index. These contracts are standardized and traded on exchanges, such as the National Stock Exchange (NSE) , the Chicago Mercantile Exchange (CME) in the US, and others.

Key Features of Equity Futures:

1. Underlying Assets:

• Stock Futures: These futures are based on the stocks of individual companies, such as Reliance Industries, Tata Consultancy Services (TCS), or HDFC Bank. Each contract specifies the quantity of shares of the stock to be bought or sold (e.g., 1,000 shares).
• Index Futures: These are based on stock market indices, such as NIFTY 50 (), Sensex, or the S&P 500 (in the US). Index futures allow investors to speculate on the overall direction of the market without dealing with individual stocks.

2. Contract Specifications:

• Size: The contract specifies the number of shares or units of the index that the buyer or seller must transact. For example, one contract of NIFTY 50 futures could represent 50 units of the NIFTY index.
• Price: The contract also specifies the price at which the trade will take place at the contract’s expiration date. The price is agreed upon when the futures contract is entered into.
• Settlement Date: Futures contracts have an expiry date, which is usually set for a particular month or date. The contract will be settled on that date based on the market price of the stock or index.

3. Leverage:

• Equity futures are traded on margin, meaning that investors do not need to pay the full contract value upfront. Instead, they are required to pay a margin deposit, which is a fraction of the total contract value.
• Leverage amplifies both the potential gains and risks. For example, with leverage, a small movement in the price of the underlying stock or index can result in a larger profit or loss for the investor.

4. Settlement:

• Physical Settlement: In physical settlement, the buyer is required to take delivery of the underlying stock, and the seller must deliver the stock on the settlement date.
• Cash Settlement: Most equity futures are cash-settled, meaning the contract is settled based on the difference between the futures price and the market price of the underlying stock or index at expiration. No physical exchange of stocks occurs.

Types of Equity Futures:

1. Single Stock Futures:

• These are futures contracts based on individual stocks. For example, a single stock future contract for Reliance Industries would obligate the buyer to purchase (or the seller to sell) 1,000 shares of Reliance at a predetermined price on the contract’s expiry date.
• Purpose: These contracts are mainly used by investors and traders to speculate on the price movements of a particular stock or to hedge against price risks in a stock portfolio.

2. Stock Index Futures:

• These futures contracts are based on a stock market index, such as NIFTY 50 (India), Sensex, or S&P 500 (US). They allow traders and investors to gain exposure to a broad market or sector without buying individual stocks.
• Purpose: Index futures are popular among institutional investors who want to hedge or speculate on the movement of the broader market, as they represent a basket of stocks rather than a single stock.
• Example: One NIFTY 50 futures contract might represent 50 units of the NIFTY index. If the NIFTY index rises by 100 points, the buyer of the contract will gain, while the seller will incur a loss.

How Equity Futures Work:

1. Entering a Futures Contract:

• To enter into an equity futures contract, an investor or trader buys or sells the contract at the current market price of the stock or index.
• The price of an equity futures contract will fluctuate throughout the trading day based on the movement of the underlying asset’s price.

2. Margin Requirement:

• To trade equity futures, the investor must deposit a margin with the exchange, which is a percentage of the total value of the contract. This margin acts as collateral to ensure the performance of the contract.
• For example, if a trader wants to buy a futures contract worth ₹10,00,000 (based on a stock index like NIFTY 50), they may only need to deposit ₹1,00,000 as margin.

3. Mark-to-Market:

• Futures contracts are marked-to-market every day. This means that the position’s profit or loss is calculated and settled daily, and the margin balance is adjusted accordingly.
• If the price of the underlying asset moves in Favor of the investor, the margin balance will increase. Conversely, if the price moves against the investor, the margin balance will decrease.

4. Closing or Settling the Position:

• The futures contract can be closed before the expiration date by taking the opposite position (i.e., selling if the position was bought, or buying if the position was sold).
• If the contract is held until expiration, it will be settled either through physical delivery (in some cases) or cash settlement (in most cases).

Uses of Equity Futures:

1. Hedging:

• Investors use equity futures to hedge against the risk of adverse price movements in stocks or indices. For example, an investor holding a large position in Reliance Industries stock may use futures to protect against potential declines in its price.
• Similarly, institutional investors can use index futures to hedge against broad market declines.

2. Speculation:

• Traders use equity futures to speculate on the future price direction of stocks or indices. By buying futures contracts, traders can profit if the price of the underlying stock or index goes up. Conversely, by selling futures contracts, they can profit if the price goes down.

3. Arbitrage:

• Traders may also engage in arbitrage strategies, where they simultaneously buy and sell the same asset in different markets (e.g., spot market and futures market) to profit from price discrepancies.

4. Leveraged Exposure:

• Since equity futures are traded on margin, investors can gain leveraged exposure to a stock or index. For example, if an investor believes that a stock will rise, they can use equity futures to gain exposure to the stock’s price movements with a smaller initial investment.

Advantages of Equity Futures:

1. Leverage: Futures contracts allow traders to control a larger position with a relatively smaller initial investment (margin).
2. Liquidity: Futures markets, especially for popular stocks and indices, tend to be highly liquid, allowing for easy entry and exit of positions.
3. Hedging and Risk Management: Equity futures are effective tools for hedging and risk management, helping investors protect themselves from adverse market movements.
4. Flexibility: Traders can use equity futures for short-term or long-term strategies, depending on their market view.

Risks of Equity Futures:

1. Leverage Risk: The use of leverage in futures contracts can magnify both gains and losses. A small adverse move in the price of the underlying asset can lead to significant losses.
2. Margin Calls: If the market moves against the trader, they may face a margin call, requiring them to deposit more funds to maintain their position.
3. Market Risk: Futures contracts are highly sensitive to market volatility. Large swings in stock prices or indices can lead to substantial profits or losses.

4.3. What are Currency Futures?

Currency Futures are standardized financial contracts that obligate the buyer to purchase, or the seller to sell, a specific amount of a currency at a predetermined exchange rate on a specified future date. These contracts are traded on regulated exchanges, such as the National Stock Exchange (NSE) or Multi Commodity Exchange (MCX) , or the Chicago Mercantile Exchange (CME) in the United States. Currency futures enable investors, traders, and businesses to hedge or speculate on the future value of one currency relative to another.

Key Features of Currency Futures:

1. Underlying Asset:

• The underlying asset in currency futures is a specific currency pair, such as USD/INR, EUR/USD, or GBP/USD.
• The value of a currency futures contract is based on the exchange rate between two currencies.

2. Contract Specifications:

• Size: A currency futures contract specifies the amount of the underlying currency to be bought or sold. For example, in the USD/INR futures market, one contract could represent 1,000 US dollars.
• Price: The contract price is the exchange rate at which the currencies are exchanged. For example, if the price of a USD/INR futures contract is 82.50, it means 1 USD is being exchanged for 82.50 INR.
• Expiry Date: Currency futures contracts have an expiration date, which could be monthly, quarterly, or on a specific day. The buyer and seller settle the contract on that date.

3. Settlement:

• Cash Settlement: Most currency futures contracts are settled in cash, meaning that no physical delivery of the currency occurs. Instead, the difference between the contract price and the spot price at expiration is paid in cash.
• Physical Settlement: Some contracts might involve the physical delivery of the underlying currency, but this is less common in the futures market for currencies.

4. Leverage:

• Currency futures are traded on margin, meaning that investors need to deposit only a fraction of the total contract value as collateral. This allows traders to gain leveraged exposure to currency movements.
• However, while leverage amplifies the potential profits, it also increases the risk of losses.

How Currency Futures Work:

1. Entering a Currency Futures Contract:

• To enter into a currency futures contract, an investor or trader will either buy or sell a contract at the current futures price.
• If an investor believes that the value of a currency will rise, they will buy the futures contract (go long). If they believe the value will fall, they will sell the contract (go short).

2. Margin Requirement:

• To trade currency futures, the trader must deposit an initial margin, which is a small percentage of the contract’s total value. This margin is intended to protect both the trader and the exchange from potential losses.
• Margin requirements are typically lower than the full value of the contract, allowing traders to control large positions with relatively small amounts of capital.

3. Mark-to-Market:

• Currency futures contracts are marked-to-market daily, meaning the contract’s value is adjusted at the end of each trading day based on the changes in the price of the underlying currency pair.
• If the market moves in favour of the trader, their margin balance increases. If the market moves against them, they may need to deposit additional funds (a margin call) to maintain the position.

4. Closing or Settling the Position:

• Traders can close their positions before the expiration date by entering into an opposite transaction (e.g., if they bought a contract, they can sell the same contract to close the position).
• If the position is held until expiration, it will be settled in cash based on the difference between the contract price and the prevailing spot market price at the time of settlement.

Uses of Currency Futures:

1. Hedging:

• Corporates and Multinational Companies use currency futures to hedge against foreign exchange risk. For example, an Indian company that exports goods to the US may sell USD/INR futures to lock in a favourable exchange rate and protect against the risk of a weaker USD in the future.
• Similarly, companies with import obligations can use currency futures to hedge against the risk of unfavourable currency fluctuations.

2. Speculation:

• Traders use currency futures to speculate on the future direction of exchange rates. For example, if a trader believes that the Indian Rupee (INR) will appreciate against the US Dollar (USD), they might buy USD/INR futures. Conversely, if they believe the INR will depreciate, they may sell the contract.
• Currency futures provide a way to profit from changes in exchange rates without having to engage in the complex foreign exchange market.

3. Arbitrage:

• Arbitrageurs use currency futures to exploit price differences between the spot market and futures market, or between different futures exchanges. This strategy typically involves buying currency futures in one market and simultaneously selling the same contract in another market to lock in a risk-free profit.

4. Portfolio Diversification:

• Investors and fund managers use currency futures as a tool to diversify their portfolios. Currency futures can act as a hedge against geopolitical or economic events that might affect specific countries or currencies.

Benefits of Currency Futures:

1. Hedging Against Exchange Rate Risk: Currency futures are an effective way for businesses and investors to protect themselves from adverse movements in exchange rates, thus ensuring greater financial stability.
2. Leverage: Currency futures offer leverage, allowing traders to control larger positions with a relatively smaller initial investment, which can magnify returns.
3. Liquidity: Currency futures markets are typically highly liquid, especially for major currencies like USD, EUR, GBP, JPY, and INR. This liquidity allows for easy entry and exit of positions.
4. Transparency and Regulation: Currency futures are traded on regulated exchanges, which ensures transparency in pricing and reduces the risk of counterparty default.
5. Low Transaction Costs: The transaction costs for currency futures are generally lower than those of spot forex trading or forward contracts, making them an attractive option for traders and businesses.

Risks of Currency Futures:

1. Leverage Risk: The use of leverage in currency futures can magnify both gains and losses. A small adverse movement in the exchange rate can result in significant losses.
2. Market Risk: Currency markets can be volatile, with prices influenced by a wide range of factors, including economic data, geopolitical events, central bank policies, and market sentiment. These factors can lead to sudden and unpredictable price movements.
3. Margin Calls: If the price of the underlying currency moves against the trader’s position, they may receive a margin call, requiring them to deposit additional funds to maintain the position.
4. Liquidity Risk: While major currency futures markets are typically liquid, smaller or less-traded currency pairs may experience lower liquidity, making it more difficult to enter or exit positions.
5. Settlement Risk: Currency futures are generally settled in cash, but for those involving physical delivery, there could be issues with settlement, especially for smaller investors who do not intend to take delivery of the underlying currency.

Currency futures are powerful tools that provide traders, businesses, and investors with the ability to hedge, speculate, and manage currency risks. These contracts allow for leveraged exposure to exchange rate movements, which can enhance potential profits but also introduce significant risks. While they offer several advantages, including low transaction costs and liquidity, they are most suitable for experienced market participants who can manage the associated risks. As with any financial instrument, a comprehensive understanding of the market and its dynamics is crucial to using currency futures effectively.

4.4  Interest Rate Futures

Interest Rate Futures  are financial derivatives that allow traders to hedge or speculate on the future direction of interest rates in the Indian financial market. These futures contracts are based on the underlying interest rates of government securities, such as 10-year Government of India (GOI) bonds, or short-term rates like the 3-month Treasury bills. Interest rate futures  are traded on regulated exchanges like the National Stock Exchange (NSE) and provide a way to manage interest rate risk for businesses, banks, investors, and financial institutions.

Key Features of Interest Rate Futures :

1. Underlying Asset:

• The underlying asset interest rate futures is typically a government bond or debt instrument. The most common type of interest rate futures is based on the 10-year Government of India (GOI) bond or a short-term government security (such as a 91-day Treasury bill).
• The price of the futures contract is determined by the interest rate (yield) on these underlying assets.

2. Contract Specifications:

• Contract Size: The standard contract size for 10-year Government of India Bond Futures is typically ₹2,000,000 (₹2 million) worth of bonds. The value of a single futures contract depends on the current market price of the bond.
• Price Quotation: The futures price is quoted in terms of the yield on the underlying bond or security. The price of an interest rate futures contract moves inversely to interest rates: when interest rates rise, the price of the futures contract falls, and when interest rates fall, the price of the contract increases.
• Expiry Date: The futures contracts on Indian government bonds generally have a maturity of three months, with contracts being traded for quarterly expiry (March, June, September, and December). At expiry, the difference between the agreed-upon futures price and the actual prevailing price of the underlying bond is settled in cash.

3. Settlement:

• Cash Settlement: Interest rate futures are typically settled in cash, meaning there is no physical delivery of the underlying bonds. The contract is settled based on the difference between the contract price (interest rate) and the prevailing market price of the underlying asset at the time of contract expiration.
• The cash settlement is the net difference between the futures contract price and the actual market price of the bond or debt instrument, which is paid to the trader who is in profit or loss.

4. Leverage:

• Interest rate futures are traded on margin, meaning traders only need to deposit a fraction of the total contract value as collateral. This allows traders to take larger positions than they would otherwise be able to, amplifying potential returns (as well as risks).
• The margin requirements are set by the exchange and vary based on the size of the position and the volatility of the underlying asset.

How Interest Rate Futures Work :

1. Entering a Position:

• Traders enter into an interest rate futures contract to either speculate on future interest rate movements or to hedge against interest rate risks. If a trader believes that interest rates will rise, they will sell futures contracts (taking a short position). If they believe interest rates will fall, they will buy futures contracts (taking a long position).
• For example, if a trader expects the yield on the 10-year Government of India bond to increase, they may sell futures contracts to profit from the expected fall in bond prices.

2. Margin Requirement:

• To participate in interest rate futures trading, traders are required to maintain a margin account. The margin is the amount of money required to open a position in the futures market and is usually a small percentage of the total contract value.
• For instance, if a trader wants to control a ₹2 million worth of bonds, they may only need to deposit a margin (e.g., 5–10% of the contract value) to take the position. The margin requirement is subject to changes based on market conditions and exchange policies.

3. Mark-to-Market:

• Interest rate futures are marked to market daily, meaning that the value of the position is recalculated every day based on the changes in the underlying asset’s value.
• If the market moves in favour of the trader’s position, their margin account is credited. Conversely, if the market moves against the position, the trader’s margin account is debited.

4. Closing or Settling the Position:

• Traders can close their position before the contract expiry by entering into an opposite transaction (buying if they initially sold, or selling if they initially bought). This helps to lock in any profit or loss.
• If the position is not closed before expiry, it will be settled in cash. The final settlement is based on the difference between the futures contract price and the actual market price of the underlying government bond or security.

Types of Interest Rate Futures :

1. 10-Year Government of India Bond Futures: These futures are based on the yield of the 10-year Government of India bonds. The futures price is determined by the yield on these bonds. This type of contract is widely used by institutional investors, such as banks and pension funds, to hedge against long-term interest rate changes.
2. Short-Term Interest Rate Futures: India also offers futures based on short-term government securities, such as 91-day Treasury Bills (T-Bills) or 182-day Treasury Bills. These futures are typically used by traders and financial institutions to hedge against short-term interest rate fluctuations or to speculate on short-term rate movements.

Uses of Interest Rate Futures :

1. Hedging Interest Rate Risk:

• Interest rate futures are widely used by financial institutions, corporations, and investors to hedge against fluctuations in interest rates. For instance, banks or companies with large debt obligations may use interest rate futures to lock in a fixed cost of borrowing by hedging against potential interest rate increases.
• Businesses with significant exposure to interest rate changes (e.g., banks, pension funds, insurance companies) can use these futures to stabilize their financial positions by mitigating the risk of rising borrowing costs or falling bond prices.

2. Speculation:

• Traders use interest rate futures to speculate on the future direction of interest rates. If a trader believes that interest rates will rise, they may sell futures contracts (go short). If they expect rates to fall, they may buy futures contracts (go long).
• Speculators typically profit from the price movements of the futures contracts rather than holding the contracts to maturity.

3. Arbitrage:

• Arbitrageurs exploit price discrepancies between the futures market and the spot market (or between different futures markets). By simultaneously buying in one market and selling in another, they can lock in a risk-free profit, provided transaction costs do not exceed the price difference.

Benefits of Interest Rate Futures :

1. Hedging Interest Rate Risk: Interest rate futures allow institutions and individuals to manage exposure to interest rate fluctuations effectively. This is especially important for businesses involved in debt financing or those that have investments sensitive to interest rate changes.
2. Liquidity: The futures markets for Indian government bonds are typically liquid, providing traders and institutions with easy entry and exit points. Liquidity ensures that futures contracts can be bought and sold without significant price disruptions.
3. Leverage: As with other futures contracts, interest rate futures offer leverage, enabling traders to control larger positions with a smaller initial margin. This can amplify potential profits, although it also increases the risk of losses.
4. Transparency and Regulation: Interest rate futures are traded on regulated exchanges like the National Stock Exchange (NSE), which ensures a transparent and secure trading environment. The clearing and settlement mechanism is handled by NSE Clearing Ltd., which reduces counterparty risk.

Risks of Interest Rate Futures :

1. Leverage Risk: The use of leverage in interest rate futures can magnify both potential gains and losses. A small adverse movement in interest rates can lead to substantial losses if the position is large.
2. Market Risk: The value of interest rate futures contracts is influenced by economic indicators, government policies, inflation expectations, and other macroeconomic factors. Unforeseen changes in these factors can lead to significant price volatility.
3. Liquidity Risk: While the market for government bond futures is generally liquid, some contracts may have lower liquidity, especially those based on short-term or less widely traded government securities.
4. Basis Risk: There may be differences between the futures price and the spot price of the underlying asset, known as basis risk. These differences arise due to factors such as transaction costs, interest rate expectations, and the time to contract maturity.

Interest rate futures provide a powerful tool for hedging against interest rate risk, speculating on interest rate movements, and managing bond portfolio durations. They offer liquidity, leverage, and a transparent market for traders, investors, and financial institutions. However, like all financial instruments, they come with risks, including market risk, leverage risk, and liquidity risk, which must be carefully managed. These futures are essential for entities that wish to navigate the complex and often volatile interest rate environment