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.

What is derivatives trading?

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

Futures contract example

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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