Futures and Forwards Markets

How Forward Contracts Work? 

Let’s consider a practical scenario involving Maruti Suzuki. The company receives a government order to supply 500 vehicles in two months. To start production, it reaches out to its regular steel vendor, CarSteel Ltd, for a price quote. 

However, Maruti anticipates that steel prices might rise due to a COVID-related lockdown in parts of China. It suspects this might lead to production halts and global supply shortages. This would raise steel prices and affect Maruti's profitability if not managed proactively. 

To safeguard its margins, Maruti negotiates a forward contract: it agrees to buy 700 tonnes of steel one month later at a fixed rate of $1,200 per tonne. 

This sets the stage for two possible outcomes:  

Scenario 1: Prices Go Up 

Due to the worsening outbreak, steel prices jump to $1,500/tonne after a month. Without the forward contract, Maruti would have paid: 

$1,500 x 700 = $1,050,000 

But thanks to the forward contract, it pays only: 

$1,200 x 700 = $840,000 

Net Savings: $210,000 

Scenario 2: Prices Drop 

If lockdowns are effective and steel production continues, prices drop to $1,150/tonne. Maruti still must pay the contracted: 

$1,200 x 700 = $840,000 

However, the market price would have resulted in: 

$1,150 x 700 = $805,000 

Net Loss: $35,000 

Even with a potential loss, Maruti prioritises predictability over price speculation, making the forward contract a tool for hedging rather than profit-making. 

Futures vs. Forwards: The Core Difference 

While forward contracts serve businesses looking to hedge against price volatility, not every market participant is focused on risk management. Some want to speculate, make directional bets on price movements. 

This need gave rise to futures contracts, a close cousin of forwards but built for broader market participation. 

What Sets Futures Apart? 

Just like forwards, futures require the buyer and seller to transact an asset at a pre-agreed price and date. But unlike the custom nature of forwards, futures contracts are: 

• Standardised in terms of size, price, and expiry 

• Traded on exchanges, offering transparency and liquidity 

• Settled on a mark-to-market basis, typically in cash 

For example, if you believe Maruti’s stock price will rise, you can purchase a futures contract at, say, ₹8,500 for a lot of 100 shares with an expiry at month-end. If the price jumps to ₹8,600 the next day, you can sell the contract and book a profit of ₹10,000, without receiving or delivering the actual shares. 

This ease of trading and potential for quick gains makes futures attractive for speculators, even though they originated as tools for hedgers. 

Evolution of the Indian Futures Market

In India, futures are actively traded on key exchanges like: 

• National Stock Exchange (NSE) 

• Bombay Stock Exchange (BSE) 

• Multi Commodity Exchange (MCX) 

• National Commodity and Derivatives Exchange (NCDEX) 

Since their inception in 2000, futures contracts have seen exponential growth, especially on the NSE, where over 5 lakh index futures contracts, worth more than ₹28,000 crore, are traded daily. In contrast, BSE’s derivatives volumes are relatively modest. 

Who Participates? 

The Indian futures ecosystem is powered by: 

• Hedgers – who use futures to lock in prices and reduce exposure to risk 

• Speculators – who aim to predict and profit from market movements 

Earlier, commodity futures were regulated by the Forward Markets Commission (FMC), set up in 1953. In a landmark move, FMC was merged with SEBI in September 2015 to unify and strengthen market oversight. 

 Points to Remember 

• Forward contracts help manage risk by locking in prices, ideal for hedging. 

• Futures contracts are traded on public exchanges and allow for both hedging and speculation. 

• India’s futures market has matured rapidly, with millions of contracts traded daily.