In this article we will understand about Future Contract vs Forward Contact and how each differ in terms of trading and settlement.

In Simple terms, forward contract and futures contract has differences in terms of:

  • Nature of Contract
  • Trading
  • Settlement
  • Risk
  • Flexibility
  • Duration
  • Forwards and Futures are types of derivative contract which derives their value from the performance of underlying assets.
  • Both these contracts allow the traders to buy or sell a certain asset at a certain price in the future.
  • Though both allow the traders to trade in the future, there are many forwards vs futures differences.
  • To understand the importance and use of both, we must know differences between these two.

Forward Contract vs future Contract

Differences: Following are the Forwards vs Futures differences that one need to know:

  • Meaning
  • Type of Contract
  • Trading
  • Transaction Method
  • Settlement
  • Counter-party Risk
  • Chances of Default
  • Size of Contract
  • Need of Collateral
  • Maturity
  • Prices
  • Price Transparency
  • Regulation
  • Liquidity
  • Closing the Contract
  • Suitable for Hedging or Speculation

What Does each contract mean :

  • Forwards contracts:
    • Forwards contracts are an agreement between two private parties to buy and sell an asset at a date in the future and at a specific price.
    • Both, the date of buying or selling and the price are set at the time of entering the contract.
    • Also, forward contracts are over-the-counter (OTC) contracts, which means they do not trade on any established stock exchange.
    • These work in accordance with the needs of counterparties, enabling customisation of contracts such as the delivery date and so on.
  • Futures Contracts:
    • Futures Contracts or Futures are also very similar to forward contracts.
    • It also includes an agreement to buy and sell an asset at a pre-defined specific rate at some time in the future.
    • The only major difference being they are standardised contracts that trade on the stock exchange.
  • Type of Contract
    • A futures contract is a standardised contract, while the forward contract is a customised or tailor-made contract.
    • Since forward contracts are tailor-made, buyers and sellers can negotiate the terms of the agreement.
  • Trading:
    • Futures contracts trade on recognized stock exchanges also known as exchange-traded markets.
    • Forwards contact, on the other hand, trades in the (OTC) over-the-counter market.
    • Or, we can say there is no secondary market.
  • Transaction Method:
    • A futures contract has standard terms and, thus, is quoted and traded on the exchange.
    • On the other hand, buyers and sellers directly negotiate the terms in a forward contract.
  • Settlement:
    • Settlement on futures contracts is on a daily basis, while for the forward contract, it is on the maturity date.
    • Futures contracts are marked to market, meaning settlement of profit or loss is on a daily basis.
  • Counter-party Risk:
    • In the case of the futures contract, the risk factor is low, while the risk factor is high in the forward’s contract as the agreement is private between two parties.
    • Thus, there is counterparty risk in the forward contracts.
    • Investors in futures are more vulnerable to fluctuations in the prices of the underlying asset as the settlement is on a daily basis.
    • In a forward contract, there is no cash exchange until maturity.
  • Chances of Default:
    • Since futures contracts trade on popular stock exchanges, the chances of default are almost negligible.
    • Clearing houses act as a guarantor in the futures market.
    • On the other hand, forward contracts are private agreements.
    • Thus the probability of default is more.
  • Size of Contract:
    • In the futures market, the contracts are standardised.
    • Therefore, the size of the contract is fixed.
    • In the forwards market, the size of the contract varies on the basis of contract terms.
  • Need of Collateral:
    • In futures contracts, traders need to put an initial margin, while there is no requirement of collateral in a forwards contract.
  • A detailed comparison is shown in the following illustration:
  • Maturity:
    • For a forward contract, the maturity is at a predetermined date, while maturity in a futures contract is as per the terms of the contract.
  • Prices:
    • In a futures contract, the price of the contract resets to zero at the end of the day.
    • In the forwards market, the contract gets more or less valuable over time.
    • Thus, the price of a futures and forward contract with the same maturity and strike price would be different.
  • Transparency:
    • There is price transparency in the futures market.
    • In the forwards market, the price is only known to the trading parties.
  • Regulations:
    • Since futures contracts trade on popular stock exchanges, they are regulated by the stock exchange.
    • Forwards contract, on the other hand, is self-regulated by the parties to the contract.
  • Liquidity:
    • Liquidity is high in the futures market, while in the forwards market, liquidity is low.
    • Since liquidity is high in the futures market, investors can enter and exit whenever they want.
  • Closing the Contract:
    • To close a futures contract, the buyer or seller needs to make a second contract, which should be the exact opposite of the original contract.
    • There are two ways to close a position in the forwards market, first, by selling the contract to a third party, and second by entering into another contract, which is the exact opposite of the first.
  • Suitable for Hedging or Speculation:
    • Traders can use futures contracts for speculation purposes.
    • On the other hand, forward contracts serve both hedging and speculation purposes.

Similarities between Forwards & Futures: Following are the similarities between Forwards and Futures contracts:

  • Both contracts are an agreement to buy and sell assets.
  • The agreement is for a future date.
  • Prices are derived from the underlying assets.
  • The two most popular uses of future and forward contracts are- hedging and speculation.

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