A future, in financial terminology, is a financial contract that obligates the buyer (seller) to purchase (sell and deliver) financial instruments or physical commodities at a future date, unless the holder's position is closed prior to expiration. Futures are often used by mutual funds and large institutions to hedge their positions when the markets are rocky, preventing large losses in value. The primary difference between options and futures is that options provide the holder the right to buy or sell the underlying asset at expiration, while futures contracts holders are obligated to fulfill the terms of their contract.

	What are forward contracts?
	What are futures contract?
	What is the difference between a forward and a futures contract?
	What are index futures?

What are forward contracts?

A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future date. Therefore, the trade date and delivery date are separate. Beside other instruments, such as Options or Futures, it is used to control and hedge risk. For examples, currency exposure risk (e.g. forward contracts on USD or Rupee) or commodity prices (e.g. forward contracts of oil). The forward price will usually give a good market estimation of the price in the future.

One party agrees to buy, the other to sell, for a forward price agreed in advance. In a forward transaction, no actual cash changes hands. If the transaction is collaterised, exchange of margin will take place according to a pre-agreed rule or schedule. Otherwise, no asset of any kind will actually change hands until the maturity of the contract.

The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands (on the spot date, usually the next business day). The difference between the spot and the forward price is the forward premium or forward discount. A forward contract is the simplest mode of a derivative transaction. No cash is exchanged when the contract is entered into.

The main features of a forward contract are:

01	It is a negotiated contract between two parties and hence exposed to counterparty risk. Example: Trade takes place between Ram and Rahim @ Rs. 100 to buy & sell commodity A. After 1 month, it is trading at Rs. 400. If Ram was the buyer he would have gained Rs. 300 & Rahim the seller, he would have lost Rs. 300. In case Rahim defaults, Ram would face counterparty risk. In case of futures contract, the exchange gives a counter guarantee to both the parties and hence even if Rahim defaulted, Ram would have gained Rs. 300.
02	Each contract is custom designed and hence unique in terms of contract size, expiration date, asset type, asset quality etc.
03	A contract has to be settled in delivery or cash on expiration date.
04	In case one of the two parties wishes to reverse a contract, he has to compulsorily go to the other party. The counter party being in a monopoly situation, can command the price he wants.

What are futures contract?

A futures contract is a form of forward contract, a contract to buy or sell an asset of any kind at a pre-agreed future point in time, that has been standardised for a wide range of uses. It is traded on a futures exchange. Futures may also differ from forwards in terms of margin and delivery requirements.

The standard terms in any futures contract are:

01	Quality of the underlying asset (not required in case of financial futures)
02	Expiration date
03	The unit of price quotation (not the price)
04	Minimum fluctuation in price (tick size)
05	Settlement style

For example: Suppose in April 2005, you are dealing in a Wipro futures contract and you know that the market lot, i.e., the minimum quantity you can buy or sell, is 1200 shares. The contract expires on April 28, 2005 (price being quoted per share) and the tick size is 5 paise per share resulting to (1200*0.05) = Rs60 per contract/ market lot. The contract would be settled in cash and the closing price in the cash market on expiry day would be the settlement price.

Since they vary in price as a direct function of these variables only, a futures contract is an example of a parametric contract and is easily combined or traded as part of more complex financial derivatives deals. Although the value of a contract at time of trading should be zero, its price constantly fluctuates. This renders the owner liable to adverse changes in value and creates a credit risk to the exchange. To minimise this risk, the exchange mandates that contract owners post a form of collateral, known as margin. The amount of margin changes each day, involving movements of cash handled by the exchange's clearing house.

Margin requirements are waived or reduced in some cases for hedgers who have physical ownership of the covered commodity or spreaders who have offsetting contracts balancing the position.

Initial margin is paid by both buyer and seller. It represents the loss on that contract, as determined by historical price changes, that is not likely to be exceeded on a usual day's trading. The price of a future is determined via arbitrage arguments.

What is the difference between a forward and a futures contract?

The differences are many and substantive:

01	Customised vs Standardised contract: Forward contracts are customised while futures contracts are standardised. Terms of forward contracts are negotiated between the buyer and the seller, while the terms of futures contracts are decided by the exchange.
02	Counter Party Risk: In forward contracts there is a risk of counter party default. In case of futures the exchange becomes counter party to each trade and guarantees settlement.
03	Liquidity: Futures are much more liquid and their price is transparent as their price and volumes are reported in the media.
04	Squaring off: A forward contract can be reversed with only the same counter party with whom it was entered into. A futures contract can be reversed on the screen of the exchange as the latter is the counter party to all futures trades.

What are index futures?

The derivatives market index run on the underlying stock/equity index. While there are many indices at both BSE and NSE and other exchanges around the country, only the 30 share BSE Sensex and the 50-share NSE S&P Nifty index can legally deal in the derivative market index. A thorough understanding of the underlying index is necessary to deal with stock index futures. Choosing the right index is important for selecting the right contract for speculation or hedging. Since for speculation, the volatility of the index is important whereas for hedging the choice of index depends upon the relationship between the stocks being hedged and the characteristics of the index, choosing and understanding the right index is important, as the movement of stock index futures is quite similar to that of the underlying stock index.

Volatility of the futures indices is generally greater than spot stock indices.Every time an investor takes a long or short position on a stock, he also has a hidden exposure to the Nifty or Sensex. Generally, stock values fall in tune with the entire market sentiment and rise when the market as a whole is rising.

Retail investors will find the index derivatives useful due to the high correlation of the index with their portfolio/stock and low cost associated with using index futures for hedging.

Index futures are all futures contracts where the underlying is the stock index (Nifty or Sensex) and helps a trader to take a view on the market as a whole.

Index futures permits speculation and if a trader anticipates a major rally in the market he can simply buy a futures contract and hope for a price rise on the futures contract when the rally occurs.

In India, we have index futures contracts based on S&P CNX Nifty and the BSE Sensex and near 3 months duration contracts are available at all times. Each contract expires on the last Thursday of the expiry month and simultaneously a new contract is introduced for trading after expiry of a contract.

Let's understand the index futures concept with a general example. After listening to the news and other occurrences in the economy, you take a view that the market would go up. You substantiate your view after talking to your near and dear ones. When the market opens, you express your view by buying XYZ stock. The whole market goes up as you expected but the price of XYZ stock falls due to some bad news related to the company. This means that while your view was correct, its expression was wrong. Using Nifty/Sensex futures you can express your view on the market as a whole. In this case you take only market risk without exposing yourself to any company specific risk. Though trading on Nifty or Sensex might not give you a very high return as trading in a stock can, yet at the same time your risk is also limited as index movements are smooth, less volatile and devoid of unwarranted swings.