Future, as the name indicates, is a trade whose settlement is going to take place in the future. However, before we take a look at futures, it will be beneficial for us to take a look at forward rate agreements.
What is a forward rate agreement?
A forward rate agreement is one in which a buyer and a seller enter into a contract at a specified quantity of an asset at a specified price on a specified date.
An example for this is the exporters getting into forward rate agreements on currencies with banks. But there is always a risk of one of the parties defaulting. The buyer may not pay up or the seller may not be able to deliver. There may not be any redressal for the aggrieved party as this is a negotiated contract between two parties.
What is a future?
A future is similar to a forward rate agreement, except that it is not a negotiated contracted but a standard instrument. A future is a contract to buy or sell an asset at a specified future date at a specified price. These contracts are traded on the stock exchanges and it can change many hands before final settlement is made. The advantage of a future is that it eliminates counterparty risk. Since there is an exchange involved in between, and the exchange guarantees each trade, the buyer or seller does not get affected with the opposite party defaulting.
| Futures | Forwards |
|---|---|
| Futures are traded on stock exchange | Forwards are non tradable, negotiated instruments |
| Futures are contracts having standard terms and conditions. | Forwards are contracts customized by the buyer and seller. |
| No default risk as the exchange provides a counter guarantee. | High risk of default by either party. |
| Exit route is provided because of high liquidity on the stock exchange. | No exit routes for these contracts. |
| Highly regulated with strong margining and surveillance. | No such systems are present in a forward market. |
There are two kinds of futures traded in the market- index futures and stock futures. There are three types of futures, based on the tenure. They are 1, 2 or 3 month future. They are also known as near and far futures depending on the tenure. What are Index futures Index futures are futures contract on the index itself. One can buy a 1, 2 or 3-month index future. If someone wants to take a call on the index, then index futures are the ideal instruments for him. Let us try and understand what an index is. An index is a set of numbers that represent a change over a period of time. A stock index is similarly a number that gives a relative measure of the stocks that constitute the index. Each stock will have a different weight in the index The Nifty comprises of 50 stocks. BSE Sensex comprises of 30 stocks. For example, Nifty was formed in 1995 and given a base value of 1000. The value of Nifty today is 1172. What it means in simple terms is that, if Rs 1000 was invested in the stocks that form in the index, in the same proportion in which they are weighted in the index, then Rs 1000 would have become Rs 1172 today.
There are two popular methods of computing the index. They are price weighted method like Dow Jones Industrial Average (DJIA) or the market capitalization method like Nifty or Sensex.
What the terminologies used in a Futures contract?
The terminologies used in a futures contract are:
- Spot Price: The current market price of the scrip/index.
- Future Price: The price at which the futures contract trades in the futures market.
- Tenure: The period for which the future is traded
- Expiry date: The date on which the futures contract will be settlec
- Basis : The difference between the spot price and the future price
Why are index futures more popular than stock futures?
Globally, it has been observed that index futures are more popular as compared to stock futures. This is because the index future is a relatively low risk product compared to a stock future. It is easier to manipulate prices for individual stocks but very difficult to manipulate the whole index. Besides, the index is less volatile as compared to individual stocks and can be better predicted than individual stock.
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