NISM Series VIII · Unit 3 of 10 · about 25% of the paper
Introduction to forwards and futures: NISM Series VIII notes and practice questions
The heaviest unit in the exam. Contract specifications, pricing, payoffs, basis, margins and hedging with index futures.
What to know in Unit 3
- Payoffs of long and short futures.
- Cost of carry pricing.
- Basis, contango and backwardation.
- Hedging with index futures.
Key terms, examples and exam traps
Long futures position
A long futures position buys the contract and gains when the price rises above the entry price and loses when it falls.
Example. A trader buys an index future at 24,000 and it moves to 24,100.
Exam trap. This statement is false: A long futures position gains when the price falls.
Short futures position
A short position sells the contract and gains when the price falls below the entry price and loses when it rises.
Example. A trader sells a future at 24,000 and it closes at 23,900.
Exam trap. This statement is false: A short futures position loses when the price falls.
Contract specification
An exchange fixes the underlying, lot size, tick size, expiry cycle and settlement method for each derivatives contract.
Example. The exchange standardises everything except the price.
Exam trap. This statement is false: Traders choose the lot size and expiry date themselves.
Tick size
The tick size is the minimum price movement allowed for a contract, such as ₹0.05 for futures on equity.
Example. A price can change only in steps of five paise.
Exam trap. This statement is false: Tick size is the lot size of the contract.
Contract value
Contract value equals futures price multiplied by the lot size and shows the exposure in rupees.
Example. A future at ₹2,000 with a lot of 500 has an exposure of ₹10 lakh.
Exam trap. This statement is false: Contract value equals the margin.
Expiry cycle
Index and stock futures have near-month, next-month and far-month contracts, and a contract expires on the day set by the exchange; on expiry it is cash settled.
Example. Three monthly contracts are available at any time.
Exam trap. This statement is false: Futures contracts have a ten-year expiry cycle.
Open interest
Open interest is the total number of outstanding contracts not yet squared off or settled, showing how many positions remain open.
Example. A count of all contracts still open at the end of the day.
Exam trap. This statement is false: Open interest is the number of contracts traded in a day.
Cost of carry
The cost of carry is the cost of holding the underlying until expiry, mainly financing cost less any income such as dividends, and drives futures pricing.
Example. A futures price is higher than spot by an amount reflecting interest costs.
Exam trap. This statement is false: Futures price is unrelated to spot price.
Contango
Contango is a market in which futures prices are higher than the spot price, normally due to carrying costs.
Example. The one-month future trades above spot.
Exam trap. This statement is false: Contango means futures trade below spot.
Backwardation
Backwardation is a market in which futures prices are lower than the spot price.
Example. A future trades at a discount to the spot price.
Exam trap. This statement is false: Backwardation means futures trade above spot.
Basis
Basis is the difference between the spot price and the futures price. It narrows to zero at expiry as the two prices converge.
Example. Spot is 24,000 and the future is 24,060; the gap shrinks as expiry nears.
Exam trap. This statement is false: Basis widens to its maximum at expiry.
Convergence
On the expiry date the futures price converges to the spot price of the underlying.
Example. On the last day the future and spot are nearly equal.
Exam trap. This statement is false: Futures and spot are unrelated at expiry.
Mark-to-market
In futures, profit or loss is settled daily against the day's settlement price, and the amounts are debited or credited to the member accounts.
Example. A trader's account is debited at the end of the day when prices fall.
Exam trap. This statement is false: Futures profits or losses are settled only at expiry.
Initial margin
Initial margin is the upfront deposit collected to cover the potential loss on a futures position over a short period. It is risk-based, using the SPAN system.
Example. A trader deposits a percentage of the contract value before taking the position.
Exam trap. This statement is false: Initial margin is refunded as profit after the first day.
Exposure margin
Exposure margin is an additional margin over and above SPAN margin, collected to cover risk beyond that measured.
Example. A buffer on top of the SPAN margin for extra safety.
Exam trap. This statement is false: Exposure margin replaces SPAN margin entirely.
SPAN
SPAN is a risk-based margining system that estimates the largest likely one-day loss across a portfolio under many scenarios.
Example. A margin system that assesses the worst-case scenario for the entire portfolio.
Exam trap. This statement is false: SPAN charges a fixed 5% on every contract.
Square off
Squaring off means closing an open position by taking an equal and opposite position in the same contract before expiry.
Example. A trader who bought a future sells the same contract to close the position.
Exam trap. This statement is false: Squaring off means doubling a position.
Rollover
Rolling over means closing a near-month position and opening a similar position in the next month to maintain exposure.
Example. A trader sells the expiring contract and buys the next month's contract.
Exam trap. This statement is false: Rollover means taking physical delivery.
Hedging with index futures
A portfolio owner can sell index futures to protect against a fall in the market; the number of contracts depends on portfolio value and beta.
Example. A fund manager sells index futures to offset a possible fall in her holdings.
Exam trap. This statement is false: Hedging requires buying index futures.
Pair trade
A pair trade buys one related security and sells another, profiting from relative price movement rather than market direction.
Example. A trader buys a bank stock future and sells another bank's future.
Exam trap. This statement is false: A pair trade is a single long position.
Cash settlement
In cash settlement, no underlying is delivered; the difference between the contract price and the settlement price is paid in cash.
Example. An index future ends with a rupee payment, not with shares.
Exam trap. This statement is false: Index futures settle with delivery of all 50 stocks.
Physical settlement
In physical settlement, the underlying shares are actually delivered on expiry; stock derivatives in India are physically settled.
Example. A stock future held to expiry results in delivery of shares.
Exam trap. This statement is false: Stock futures are always cash settled.
Single-stock futures
Single stock futures are futures on individual shares, available for eligible stocks with liquidity and market-cap criteria.
Example. A contract on a single company's share, with a fixed lot size.
Exam trap. This statement is false: Single-stock futures are available for any listed company.
Index futures
Index futures are contracts on stock indices such as the Nifty 50, are cash settled, and are widely used to hedge and speculate on the overall market.
Example. A trader takes a view on the market as a whole with one contract.
Exam trap. This statement is false: Index futures are delivered in shares.
Long hedge versus short hedge
A short hedge sells futures to protect against price falls; a long hedge buys futures to protect against price rises.
Example. A person expecting to buy shares next month buys futures to lock in prices.
Exam trap. This statement is false: A short hedge buys futures contracts.
Fair value of futures
The fair price of a futures contract is the spot price plus the net cost of carry; deviations create arbitrage opportunities.
Example. A future priced well above spot plus carry attracts arbitrage sellers.
Exam trap. This statement is false: Futures can trade at any price without arbitrage.
Cash-and-carry arbitrage
Cash-and-carry arbitrage buys the underlying in the cash market and sells the future when the future is expensive relative to fair value.
Example. A trader buys shares and sells the future, locking in a gap.
Exam trap. This statement is false: Cash-and-carry arbitrage buys futures and sells shares.
Reverse cash-and-carry
Reverse cash-and-carry sells the underlying and buys the future when the future is cheap relative to fair value.
Example. A trader sells shares and buys a cheap future to lock in a gain.
Exam trap. This statement is false: Reverse cash-and-carry buys the underlying and sells futures.
Futures versus forwards risk
Exchange-traded futures remove counterparty risk through the clearing corporation, while forwards leave it with the counterparty.
Example. A clearing corporation guarantees that the futures trade will be honoured.
Exam trap. This statement is false: Forward contracts are guaranteed by the exchange.
Futures margin and leverage
Because only margin is paid upfront, futures offer leverage: a small price change can produce a large percentage gain or loss on margin.
Example. A 2% price move creates a 15% change in the trader's margin capital.
Exam trap. This statement is false: Futures margin limits the loss to the margin amount.
6 practice questions
Read each question and choose your answer before opening the free mock, which shows the correct answer and the reason.
Q1. Which statement best describes “Expiry cycle”?
- Basis is the difference between the spot price and the futures price. It narrows to zero at expiry as the two prices converge.
- Index and stock futures have near-month, next-month and far-month contracts, and a contract expires on the day set by the exchange; on expiry it is cash settled.
- Contango is a market in which futures prices are higher than the spot price, normally due to carrying costs.
- When a buyer exercises, a seller is assigned at random or by rule and must perform the obligation under the contract.
Q2. Which statement best describes “Cash-and-carry arbitrage”?
- Intrinsic value is the amount by which an option is in the money, and is never negative. For a call it is the greater of (spot − strike) and zero.
- Cash-and-carry arbitrage buys the underlying in the cash market and sells the future when the future is expensive relative to fair value.
- Index futures are contracts on stock indices such as the Nifty 50, are cash settled, and are widely used to hedge and speculate on the overall market.
- Exchanges list options with weekly expiries on selected indices, subject to regulatory limits on the number of contracts.
Q3. Which statement best describes “Tick size”?
- Brokers must distinguish their own proprietary trades from client trades and ensure they are reported and handled separately.
- The tick size is the minimum price movement allowed for a contract, such as ₹0.05 for futures on equity.
- A pair trade buys one related security and sells another, profiting from relative price movement rather than market direction.
- Stocks are admitted to derivatives based on criteria such as market capitalisation, free float, trading frequency and volatility.
Q4. Which term is described here? Reverse cash-and-carry sells the underlying and buys the future when the future is cheap relative to fair value.
- Tax audit
- Conflict of interest
- Reverse cash-and-carry
- Free-float weighting
Q5. Which term is described here? A portfolio owner can sell index futures to protect against a fall in the market; the number of contracts depends on portfolio value and beta.
- Hedging with index futures
- Implied volatility
- Turnover for derivatives
- Open interest
Q6. Which statement best describes “Short futures position”?
- Leverage in derivatives means controlling a large exposure with a small margin, magnifying both gains and losses.
- Index constituents are reviewed periodically and stocks replaced when they no longer meet criteria on market cap, liquidity and free float.
- A short position sells the contract and gains when the price falls below the entry price and loses when it rises.
- An index starts at a base value on a base date; the Nifty 50 base is 1000 and the Sensex base is 100, and later values are relative to them.
Frequently asked questions
How much of NISM Series VIII comes from Unit 3?
Unit 3 (Introduction to forwards and futures) usually carries about 25% of the questions. The whole exam has 100 questions and the pass mark is 60%.
What should I study in NISM Series VIII Unit 3?
Payoffs of long and short futures. Cost of carry pricing. Basis, contango and backwardation. Hedging with index futures.
Are these NISM Series VIII practice questions free?
Yes. Take the full free mocks to see the correct answer and the reason for every question.
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