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Difference Between Forward and Futures Contracts

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Derivatives are becoming an increasingly popular tool to manage risk. Multiple derivative instruments help traders hedge against sudden price fluctuations or take advantage of market volatility. Futures and forwards are among the most popular derivative instruments used by traders. This article aims to elaborate on the difference between forward and future contracts.

Forward Contracts vs. Futures Contracts: An Overview

Forward contracts and futures contracts serve as essential financial instruments used for hedging and speculation in derivatives trading. A forward contract is a customized agreement between two parties to buy or sell an asset at a specified future date for a price agreed upon today. These contracts are typically traded over-the-counter (OTC), allowing for greater flexibility in terms and conditions. In contrast, futures contracts are standardized agreements traded on exchanges, which ensures liquidity and regulatory oversight. They obligate the buyer to purchase, and the seller to sell, an asset at a predetermined price at a future date.

The difference between forward and futures contracts lies primarily in their trading venues, standardization, and counterparty risk. Futures contracts are marked to market daily, whereas forwards settle at expiration, which can lead to varying degrees of risk. Understanding these differences is crucial for traders looking to effectively manage risk and capitalize on market opportunities.

Derivatives typically have an underlying asset associated with them. Derivative trading is carried out based on the price fluctuations of the asset, which could be in the form of stocks, commodities, bonds etc. We can trade Derivatives in two ways: (i) when the stock exchange acts as a counterparty, derivatives are traded as standardised financial contracts. These are also known as exchange-traded derivatives, (ii) over-the-counter derivatives, i.e., without the intervention of a formal intermediary.

What is a futures contract?

A futures contract is an agreement between two entities to conduct a transaction at a locked-in price at a predetermined date in the future. The futures contract buyer is not required to pay the entire amount upfront. Instead, only a small initial outlay must be paid, which makes futures trading highly leveraged. The standard terms and conditions of a futures contract are:

  • Date of delivery
  • Trade volume
  • Credit procedure
  • Other technical specifications

Examples of Forward Contracts and Futures Contracts

Understanding the practical applications of forward and futures contracts is essential for grasping their roles in the financial markets.

A forward contract is often utilized by businesses to hedge against price fluctuations in commodities. For instance, a coffee shop may enter a forward contract to purchase coffee beans at a fixed price six months in advance, protecting itself from potential price increases due to market volatility.

On the other hand, futures contracts are widely used in financial markets for trading various assets, including commodities, currencies, and indices. For example, a farmer may sell a futures contract for wheat at a predetermined price before harvest to lock in profits, while investors can trade crude oil futures to speculate on price changes.

These examples highlight the difference between forward and futures contracts in terms of flexibility and risk management strategies, illustrating how they serve distinct but complementary purposes in trading and hedging.

Let us understand how futures contracts work with some examples.

  • Suppose you enter a futures contract, taking currency as the underlying asset. A futures contract allows you to exchange between currencies at a pre-specified rate on a fixed date in the future. In this case, the agreement helps you hedge against unfavourable currency movements.
  • Let us examine another scenario where you enter stock futures. A specific stock is trading at Rs. 100/share. Your futures contract entitles you to purchase the same stock for Rs. 50/share. You exercise your contract and sell the stock at an instant profit of Rs. 50/share. The net profit may be slightly diminished, considering margin, fees and commissions. However, you still make a substantial profit on the underlying stock.

What is a forward contract?

A forward contract is a privately negotiated agreement between two entities that comprises buying or selling an underlying asset at a pre-set date and an agreed-upon price. Such contracts can be traded in different over-the-counter derivatives such as commodities, stocks etc.

FeaturesForward ContractFuture Contract
RegulationSelf-regulated.Regulated by the Securities and Exchange Board of India (SEBI).
CollateralForward contracts do not require an initial margin.Futures contracts require a specific margin following the regulations of the exchange.
MaturityForward contracts may be set to mature on the date as decided upon in terms of the private contract.Futures contracts mature on a predetermined date.
SettlementThe parties entering the contract may negotiate the settlement terms. Settlement of Forward contracts happens upon maturity.The exchange settles futures contracts daily.

Other Key differences

Here are some of the other significant features of forward contract vs future contract.

  1. Structure -

    Futures contracts come in a well-defined form. However, the structure of forward contracts may vary depending on the negotiated terms of the parties. Additionally, futures contracts are more liquid as compared to forwards.
  2. Risk -

    Forward contracts are much riskier as compared to futures. Since an intermediary does not regulate forward contracts, they may be prone to default and counterparty risks. On the other hand, the Exchanges regulate future contracts, which makes them less risky. The Exchanges follow mark-to-market settlement, i.e., all the market positions are recorded by the Exchanges by the end of each trading day. Therefore, the regulatory bodies safeguard future contracts from default or counterparty risks.
  3. Pricing -

    The pricing of futures contracts is based on an efficient price discovery mechanism. However, forwards may be prone to pricing inefficiencies since they do not follow a centralised framework. Another distinguishing feature between forwards and futures is the transparency in the pricing mechanism. While futures pricing is highly transparent, the forwards are priced exclusively between the two parties entering the contract.

Conclusion

Forward and future contracts can provide excellent means to manage strategies and hedge against price fluctuations. The difference between futures and forwards is that futures provide standardised contracts, whereas forwards are based on customisable contracts involving two parties. However, since the exchange regulates futures, they are not exposed to risks such as default or counterparty risk.

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Frequently Asked Questions

What is a Forward Contract?

Answer Field

A forward contract is a customized agreement between two parties to buy or sell an asset at a specified future date for a price agreed upon today. It is typically traded over-the-counter (OTC), allowing for flexibility in terms and conditions.

What is a Futures Contract?

Answer Field

A futures contract is a standardized agreement to buy or sell a specific asset at a predetermined price at a specified future date. Unlike forward contracts, futures are traded on exchanges, providing liquidity and regulatory oversight.

How do Forward Contracts and Futures Contracts differ?

Answer Field

The main difference between forward and futures contracts lies in their standardization and trading venues. Futures contracts are standardized and exchange-traded, while forward contracts are customizable and traded OTC. This results in varying degrees of counterparty risk and flexibility.

What are the main features of Forward Contracts?

Answer Field

Forward contracts are private agreements that allow for customization of terms, including price and delivery date. They carry counterparty risk since they are not traded on an exchange and typically settle at expiration.

What are the main features of Futures Contracts?

Answer Field

Futures contracts are standardized, ensuring that each contract specifies the same quantity and quality of the asset. They are traded on exchanges, which minimizes counterparty risk through the use of clearinghouses and require daily settlement through mark-to-market pricing.

How is pricing determined in Forward Contracts vs. Futures Contracts?

Answer Field

Pricing in forward contracts is determined by the parties involved and is based on the current market conditions and expectations. In contrast, futures prices are influenced by market supply and demand and are adjusted daily based on market fluctuations.

Are Forward Contracts standardized?

Answer Field

No, forward contracts are not standardized. They are customized agreements tailored to the specific needs of the parties involved, allowing for variations in terms such as delivery dates, contract size, and pricing mechanisms. This flexibility makes forward contracts suitable for specific hedging requirements but also introduces counterparty risk.

What are the settlement processes for Forward and Futures Contracts?

Answer Field

Forward contracts are settled at the end of the contract period, typically through the physical delivery of the underlying asset or cash settlement based on the agreed-upon price. In contrast, futures contracts are settled daily through a mark-to-market process, where gains and losses are calculated based on market prices, allowing for more immediate adjustment of positions.

How are risks managed in Forward vs. Futures Contracts?

Answer Field

Risks in forward contracts are managed through negotiation and contract terms, which may include collateral arrangements. In futures contracts, risks are managed through daily settlements, clearinghouses, and margin requirements, which help reduce counterparty risk.

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