Difference between a Futures Contract and a Forward Contract

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Forward Contracts vs. Futures Contracts: What’s the Difference?

Forward Contracts vs. Futures Contracts: An Overview

Forward and futures contracts are similar in many ways: both involve the agreement to buy and sell assets at a future date and both have prices that are derived from some underlying asset. A forward contract, though, is an arrangement made over-the-counter (OTC) between two counterparties that negotitate and arrive on the exact terms of the contract – such as its expiration date, how many units of the underlying asset are represented in the contract, and what exactly the underlying asset to be delivered is, among other factors. Forwards settle just once at the end of the contract. Futures, on the other hand, are standardized contracts with fixed maturity dates and uniform underlyings. These are traded on exchanges and settled on a daily basis. 

Key Takeaways

  • Both forward and futures contracts involve the agreement between two parties to buy and sell an asset at a specified price by a certain date.
  • A forward contract is a private and customizable agreement that settles at the end of the agreement and is traded over-the-counter.
  • A futures contract has standardized terms and is traded on an exchange, where prices are settled on a daily basis until the end of the contract.

Forward Contracts

The forward contract is an agreement between a buyer and seller to trade an asset at a future date. The price of the asset is set when the contract is drawn up. Forward contracts have one settlement date—they all settle at the end of the contract.

These contracts are private agreements between two parties, so they do not trade on an exchange. Because of the nature of the contract, they are not as rigid in their terms and conditions.

Many hedgers use forward contracts to cut down on the volatility of an asset’s price. Since the terms of the agreement are set when the contract is executed, a forward contract is not subject to price fluctuations. So if two parties agree to the sale of 1000 ears of corn at $1 each (for a total of $1,000), the terms cannot change even if the price of corn goes down to 50 cents per ear. It also ensures that delivery of the asset, or, if specified, cash settlement, will usually take place.

Because of the nature of these contracts, forwards are not readily available to retail investors. The market for forward contracts is often hard to predict. That’s because the agreements and their details are generally kept between the buyer and seller, and are not made public. Because they are private agreements, there is a high counterparty risk. This means there may be a chance that one party will default.

Forward Contract vs. Futures Contract

A forward contract is a customized contractual agreement where two private parties agree to trade a particular asset with each other at an agreed specific price and time in the future. Forward contracts are traded privately over-the-counter, not on an exchange.

A futures contract — often referred to as futures — is a standardized version of a forward contract that is publicly traded on a futures exchange. Like a forward contract, a futures contract includes an agreed upon price and time in the future to buy or sell an asset — usually stocks, bonds, or commodities, like gold.

The main differentiating feature between futures and forward contracts — that futures are publicly traded on an exchange while forwards are privately traded — results in several operational differences between them. This comparison examines differences like counterparty risk, daily centralized clearing and mark-to-market, price transparency, and efficiency.

Comparison chart

Forward Contract versus Futures Contract comparison chart
Forward Contract Futures Contract
Definition A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time at a specified price. A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price.
Structure & Purpose Customized to customer needs. Usually no initial payment required. Usually used for hedging. Standardized. Initial margin payment required. Usually used for speculation.
Transaction method Negotiated directly by the buyer and seller Quoted and traded on the Exchange
Market regulation Not regulated Government regulated market (the Commodity Futures Trading Commission or CFTC is the governing body)
Institutional guarantee The contracting parties Clearing House
Risk High counterparty risk Low counterparty risk
Guarantees No guarantee of settlement until the date of maturity only the forward price, based on the spot price of the underlying asset is paid Both parties must deposit an initial guarantee (margin). The value of the operation is marked to market rates with daily settlement of profits and losses.
Contract Maturity Forward contracts generally mature by delivering the commodity. Future contracts may not necessarily mature by delivery of commodity.
Expiry date Depending on the transaction Standardized
Method of pre-termination Opposite contract with same or different counterparty. Counterparty risk remains while terminating with different counterparty. Opposite contract on the exchange.
Contract size Depending on the transaction and the requirements of the contracting parties. Standardized
Market Primary & Secondary Primary

Contents: Forward Contract vs Futures Contract

Trade Procedure

In a forward contract, the buyer and seller are private parties who negotiate a contract that obligates them to trade an underlying asset at a specific price on a certain date in the future. Since it is a private contract, it is not traded on an exchange but over the counter. No cash or assets change hands until the maturity date of the contract. There is usually a clear “winner” and “loser” in forward contracts, as one party will profit at the point of contract maturity, while the other party will take a loss. For example, if the market price of the underlying asset is higher than the price agreed in the forward contract, the seller loses. The contract may be fulfilled either via delivery of the underlying asset or a cash settlement for an amount equal to the difference between the market price and the price set in the contract i.e., the difference between the forward rate specified in the contract and the market rate on the date of maturity. For an intro to forward contracts, watch this video from Khan Academy.

Whereas a forward contract is a customized contract drawn up between two parties, a futures contract is a standardized version of a forward contract that is sold on a securities exchange. The terms that are standardized include price, date, quantity, trading procedures, and place of delivery (or terms for cash settlements). Only futures for assets standardized and listed on the exchange can be traded. For example, a farmer with a corn crop might want to lock in a good market price to sell his harvest, and a company that makes popcorn might want to lock in a good market price to buy corn. On the futures exchange, there are standard contracts for such situations — say, a standard contract with the terms of “1,000 kg of corn for $0.30/kg for delivery on 10/31/2020.” here are even futures based on the performance of certain stock indices, like the S&P 500. For an intro to futures, watch the following video, also from Khan Academy:

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Investors trade futures on the exchange through brokerage firms, like E*TRADE, that have a seat on the exchange. These brokerage firms take responsibility for fulfilling contracts.

Closing a Position

To close a position on a futures trade, a buyer or seller makes a second transaction that takes the opposite position of their original transaction. In other words, a seller switches to buying to close his position, and a buyer switches to selling. For a forward contract, there are two ways to close a position — either sell the contract to a third party, or get into a new forward contract with the opposite trade.

Standardizing a contract and trading it on an exchange provides some valuable benefits to futures contracts, as discussed below.

Forward contracts are subject to counterparty risk, which is the risk that the party on the other side of the trade defaults on their contractual obligation. For example, AIG’s insolvency during the 2008 crisis subjected many other financial institutions to counterparty risk because they had contracts (called credit default swaps) with AIG.

The futures exchange’s clearinghouse guarantees transactions, thereby eliminating counterparty risk in futures contracts. Of course, there is the risk that the clearinghouse itself will default, but the mechanics of trading are such that this risk is very low. Futures traders are required to deposit money — usually 10% to 20% of the contract value — in a margin account with the brokerage firm that represents them on the exchange to cover their exposure. The clearinghouse takes positions on both sides of a futures trade; futures are marked to market every day, with the brokers making sure there are enough assets in margin accounts for traders to cover their positions.

Margin Calls

Futures and forwards also carry market risk, which varies depending on the underlying asset it. Investors in futures, however, are more vulnerable to volatility in the price of the underlying asset. Because futures are marked to market daily, investors are liable for losses incurred daily. If the asset price fluctuates so much that the money in an investor’s margin account falls below the minimum margin requirement, their broker issues a margin call. This requires the investor to either deposit more money in the margin account as collateral against further losses, or be forced to close their position at a loss. If the underlying asset swings in the opposite direction after the investor is forced to close their position, they lose out on a potential gain.

With forward contracts, no cash is exchanged until the maturity date. So in that scenario, the holder of a forward contract would still end up ahead.

Prices

The price of a futures contract resets to zero at the end of every day because daily profits and losses (based on the prices of the underlying asset) are exchanged by traders via their margin accounts. In contrast, a forward contract starts to become less or more valuable over time until the maturity date, the only time when either contracting party profits or loses.

So on any given trading day, the price of a futures contract will be different from a forward contract that has the same maturity date and strike price. The following video explains price divergence between futures and forward contracts:

Liquidity and Price Transparency

It is easy to buy and sell futures on the exchange. It is harder to find a counterparty over-the-counter to trade in forward contracts that are non-standard. The volume of transactions on an exchange is higher than OTC derivatives, so futures contracts tend to be more liquid.

Futures exchanges also provide price transparency; prices for forward contracts are only known to the trading parties.

Regulation

Futures are regulated by a central regulatory authority like the CFTC in the United States. On the other hand, forwards are governed by the applicable contract law.

Volumes

The majority of futures trading takes place in North America and Asia and deals with individual equities.

Difference Between Forward and Futures Contract

Last updated on May 24, 2020 by Surbhi S

A forward contract is a contract whose terms are tailor-made i.e. negotiated between buyer and seller. It is a contract in which two parties trade in the underlying asset at an agreed price at a certain time in future. It is not exactly same as a futures contract, which is a standardized form of the forward contract. A futures contract is an agreement between parties to buy or sell the underlying financial asset at a specified rate and time in future.

While a futures contract is traded in an exchange, the forward contract is traded in OTC, i.e. over the counter between two financial institutions or between a financial institution or client.

As in both the two types of contract the delivery of the asset takes place at a predetermined time in future, these are commonly misconstrued by the people. But if you dig a bit deeper, you will find that these two contracts differ in many grounds. So, here in this article, we are providing you all the necessary differences between forward and futures contract so that you can have a better understanding about these two.

Content: Forward Contract Vs Future Contract

Comparison Chart

Basis for Comparison Forward Contract Futures Contract
Meaning Forward Contract is an agreement between parties to buy and sell the underlying asset at a specified date and agreed rate in future. A contract in which the parties agree to exchange the asset for cash at a fixed price and at a future specified date, is known as future contract.
What is it? It is a tailor made contract. It is a standardized contract.
Traded on Over the counter, i.e. there is no secondary market. Organized stock exchange.
Settlement On maturity date. On a daily basis.
Risk High Low
Default As they are private agreement, the chances of default are relatively high. No such probability.
Size of contract Depends on the contract terms. Fixed
Collateral Not required Initial margin required.
Maturity As per the terms of contract. Predetermined date
Regulation Self regulated By stock exchange
Liquidity Low High

Definition of Forward Contract

A forward contract is a private agreement between the buyer and seller to exchange the underlying asset for cash at a particular date in the future and at a certain price. On the settlement date, the contract is settled by physical delivery of asset in consideration for cash. Settlement date, quality, quantity, rate and the asset are fixed in the forward contract. Such contracts are traded in a decentralized market, i.e. Over the counter (OTC) where the terms of the contract can be customized as per the needs of the parties concerned.

The buyer in a forward contract is considered as long, and his position is assumed as long position while the seller is called short, holds a short position. When the price of the underlying asset rises and is more than the agreed price, the buyer makes a profit. But if the prices fall, and is less than the contracted price the seller makes a profit.

Definition of Futures Contract

A binding contract which is executed at a later date is a future contract. It is an exchange-traded contract of the standardized nature where two parties, decides to exchange an asset, at an agreed price and future specified a date for delivery and payment. A future contract is a standardized in terms of the quantity, date, and delivery of the item. The buyer holds long position while the seller holds a short position in this contract.

As the contracts are traded in the official exchange, which acts as both mediator and facilitator between the buyer and seller. The exchange has made it mandatory for both the parties to pay an upfront cost as a margin.

The unique feature of the future contract is marking to a market where the prices are subject to fluctuations. Hence, the differences in the price of contracts are settled daily. Further, the futures are divided into two broad categories, which are:

  • Commodity Futures: The contract whose subject matter is commodities such as aluminum, gold, coffee, sugar etc.
  • Financial futures: The contract which deals with financial instruments like treasury bill, currency and so on.

Key Differences Between Forward and Futures Contract

The basic differences between forward and futures contract are mentioned below:

  1. An agreement between parties to buy and sell the underlying asset at a certain price on a future date is a forward contract. A future contract is a binding contract whereby the parties agree to buy and sell the asset at a fixed price and a future specified date.
  2. The terms of a forward contract are negotiated between buyer and seller. Hence it is customizable. Conversely, a futures contract is a standardized one where the conditions relating to quantity, date, and delivery are standardized.
  3. Forward contracts are traded Over the Counter (OTC), i.e. there is no secondary market for such contracts. On the other hand, a Futures contract is traded on an organized securities exchange.
  4. When it comes to settlement, forward contracts settle on a maturity date. As compared to the future contract which is marked to market on a daily basis, i.e. the profit or losses are settled daily.
  5. There is a high counterparty risk in case of forward contract as compared to a futures contract.
  6. In the case of a forward contract, there are high chances of default by a party, as the agreement is private in nature. Unlike a future contract, where clearing houses are involved, that guarantees the transaction, so the possibility of default is almost nil.
  7. If we talk about the size of the contract, in a forward contract, it depends on the terms of the contract, whereas the size is fixed in case of the futures contract.
  8. The maturity of the contract is as per the contractual terms in the forward contract while the same is predetermined in the futures contract.
  9. In forward contracts, there is no requirement of collateral, but in futures contracts, initial margin is required.
  10. Forward contracts are self-regulated. Unlike futures contracts, which are regulated by the securities exchange.

Conclusion

As per the above discussion, it can be said that there are several dissimilarities between these two contracts. The credit risk in a forward contract is relatively higher that in a futures contract. Forward contracts can be used for both hedging and speculation, but as the contract is tailor made, it is best for hedging. Conversely, futures contracts are appropriate for speculation.

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