From the point of view of settlement, there are 2 types of futures contracts - those that provide for physical delivery (in the case of commodities) and those, which are settled in cash. The delivery or settlement is a pre-decided feature of the contract. The month and date during which delivery or settlement is to occur is specified. Thus, if you were to purchase a July futures contract, it would be due for delivery or settlement on the last Thursday in July.

A more popular classification of futures contracts however is based on the underlying asset. There are four popular financial commodities, which become underlying assets in futures. These are:

1. Currencies (‘currency futures’). The underlying asset is a currency (say the US dollar).
2. A stock market index (‘index futures’). The underlying asset is a stock market index (such as the NSE Nifty index).
3. Interest rates (‘interest rate futures’). The underlying asset is an interest-earning debt security (such as a Treasury Bill).
4. Stocks (‘stock futures’). The underlying asset is an individual stock (say shares of ABC Ltd.).

1. Liquidity while trading
Futures contracts are standardized in terms of quantity and quality (in the case of commodities) of the product traded, contract price and settlement mechanism. Further, these are traded on exchanges, as opposed to being tailor made to cater to the needs of only the parties involved. As a result of these standardized features and the fact that these products are traded on exchanges, there is always a ready market for them.

2. No counter party risk
Futures contracts are absolutely risk-free as regards counter party risks (the risk that one of the parties to the contract may default) for both buyers and sellers. This is so because this risk is assumed by the clearing house, which becomes the counter party to all the trades or unconditionally guarantees their settlement. So, if you were to purchase a futures contract, you would, in effect, be purchasing it from the exchange and hence you would be dealing directly with the exchange who would guarantee your trade. As the financial integrity of the entire system is ensured by the exchange through the clearing house, credit risk of the transactions is eliminated.

3. Better price discovery
The obvious corollary to the above two points is that efficient markets ensure better price discovery in the case of futures contracts. Electronic exchange based trading creates a common ground for buyers and sellers, ensuring larger volumes and minimized price manipulation.

A futures transaction always has two parties, a buyer and a seller. If you buy a contract, it is called taking a long position, and if you sell a contract, you are taking a short position. In the futures market, every contract has an equal number of long and short positions.

When you buy or sell a futures contract, you will simply be buying or selling a specific type and quantity of the underlying asset at an agreed price, for delivery or final settlement at a future date.

It may appear that you are obligated to hold the futures contract till maturity (expiration). However, in reality, you may also square up your position in the contract with an offsetting trade (selling the same number and type of futures that you have purchased earlier and vice versa) at any time before the expiry of the contract.

With financial futures products, settlement of a contract at maturity is in cash rather than by physical delivery. Commodity futures, however, can be settled by delivery, i.e. actually taking delivery of the physical commodity depending upon the contract specifications.

The theoretical way of pricing any future is to factor in the current price and holding costs (called ‘the cost of carry’) i.e. Futures Price = Spot Price + Cost of Carry where:

• The spot price = the price at which the underlying asset is currently trading in the cash market; and,
• The cost of carry = the sum of all costs incurred if you take a similar position in the cash market and carry it to the maturity of the futures contract, less any revenue which may accrue during this period. The costs typically include interest, in case of financial futures, or interest, insurance and storage costs in case of commodity futures. The revenue may be dividends, in case of stock futures.

To take a simplified example - If you buy 100 shares of XYZ Ltd. in the cash market at Rs 120 each and hold them for the next 3 months, you would have invested Rs 12,000 (100 x 120). Instead, if you had purchased 100 futures of XYZ Ltd, you would only be required to invest say, 20 per cent of the value in the form of margin i.e. Rs 2,400.  By purchasing the shares in the cash market, you are losing interest on part of your capital, i.e. Rs 9,600 (Rs 12,000 – Rs 2,400) for 3 months. If the interest cost is 7 per cent, you are in effect losing Rs 168 (7 per cent of Rs 9,600 for 3 months). Theoretically, this will become your ''cost of carry'' that is added to the cash price to arrive at the 3 month futures price. Apart from this theoretical value, the actual value may vary depending on the demand-supply of the underlying asset at present and expectations about the future.

Basis = Futures price – Spot price

The difference between the price of the underlying asset in the cash market and the futures price is called the basis. As a futures contract reaches its expiry date, the basis tends to become less till it becomes zero at the time of settlement. This is because the futures contract is settled at the closing market price of the underlying asset.

In general, since the futures price is greater than the spot price, the basis is positive. However, at times, the futures price may be lower than the spot price. This may happen when expectations are bearish in the near future or the cost of carry is negative etc.

Operators in the futures markets can be broadly categorized in the following 3 kinds:

1. Hedgers
Hedgers are the players who protect their long / short positions in their regular business or trading ventures by entering the futures markets. Let’s say you own 100 shares of ABC Ltd. If you fear that the price of these shares will fall in the near future, you could protect yourself financially, by selling ABC Ltd. futures in the market. Here''s how you remain insulated from any fall in price. If the cash market price of ABC Ltd. at present is Rs 130 per share, you should sell futures comprising of the same number of shares that you hold, i.e. 100 shares, at a futures price that is as close to the prevailing current price. For simplicity sake, let''s say you manage to sell futures at Rs 130 per share.

 
Three months later, if the price of ABC Ltd. has fallen to Rs 110 you would have made a loss of Rs 2,000 (Rs 20 x 100 shares) in your shares. However, your futures contract will be settled at Rs 110 per share, giving you a gain of Rs  2,000 (Futures sale price of Rs 130 - settlement price of Rs 110 x 100 shares). Thus, your net value of holding is protected.

Similarly, if the price of ABC Ltd. in the cash market rises, the value of your net holdings will still remain unchanged, since the appreciation in your shares will be nullified by the loss that you make by settling your futures at a higher price than your selling price.

2. Speculators
Speculators accept risk in pursuit of profit. This is a highly specialized business and speculators’ success is dependent on their ability to forecast the future prices of the underlying assets accurately. As opposed to hedgers, they take naked positions in the futures market i.e. they go long or short in various futures contracts available in the market (without owning the underlying asset). Speculators perform a very important function by acting as counter parties to hedgers. It can hence be said that derivatives facilitate the transfer of risk from hedgers to speculators.

3. Arbitrageurs
Arbitrageurs lock in their non-speculative profits by operating in various markets simultaneously (long in one market and short in another market). In the process, they remove mis-pricing, if any, in either the cash or derivatives markets and align the prices through operating in both the markets.

Speculators and arbitrageurs give enormous liquidity to the products traded on the exchanges. This liquidity, in turn, results in better price discovery, lower transaction costs and less manipulation of the market.