Difference Between Futures and Forwards
- 02 Mar 2024
- By: BlinkX Research Team
The difference between Futures and Forwards contracts is based on the need for customisation versus standardisation. A forward contract is fully customised, while a futures contract is standardised and exchange-traded. Both involve an agreement to buy or sell an asset at a future date at a price determined today. However, forwards are customised and over-the-counter (OTC) products, while futures are standardised and exchange-traded.
The key difference between forwards and futures is that forwards are over-the-counter (OTC) products, while futures are standardised and exchange-traded. In derivatives, forwards contracts are used, while forwards contracts are used in derivatives.
In summary, forwards and futures are similar in structure and pay-offs, but their legal implications differ. Both involve an agreement between two parties to buy or sell an asset on a specific date in the future, at the price and other terms decided now. However, forwards are over-the-counter (OTC) contracts, while futures are exchange-traded contracts, making them more secure and standardized.
Understanding Forward Contract
Forwards are agreements between two parties to buy/sell the underlying asset at a certain price at a predetermined period. Only the profit and loss accumulated at the settlement date are known in this sort of contract.
A Forward Contract can be traded in a variety of over-the-counter derivatives such as stocks, commodities, currencies, and others. These contracts can be exchanged off-exchange rather than on the exchange.
Example: Let's use a forward contract example to further grasp the idea. Assume a farmer will harvest 20 tonnes of corn by the next year. He has to sell his produce for at least Rs 10,000 per tonne to break even. The farmer may or may not be able to turn a profit on the sale if he decides to hold off until the next year to sell his crop of maize. This is because it is impossible to predict the price per tonne for the upcoming year.
Table of Content
- Understanding Forward Contract
- Understanding Future Contract
- Difference Between Future and Forward Contracts
- Key difference between Futures and Forwards
- Similarities between Future and Forward contracts
Understanding Future Contract
It is a standardised financial contract in which a quantity and price are specified and the payment is payable at a future period. It is also known as Futures. These contracts can be traded on stock markets in a variety of areas, including stocks, currencies, and commodities. You should be aware that the parties concerned are legally obligated to carry out the contract. The Futures Contract has the following standardised terms and conditions.
Example:
Consider an oil producer who wants to sell oil but is concerned about the potential decline in oil prices. A futures contract can be used to guarantee that the oil producer receives the set price and avoids suffering a loss.
The oil producer can send the oil to the buyer after the future contract expires by using future contracts to lock in the price at which the oil will sell.
On the other hand, a manufacturing firm could need oil to utilise in the production of widgets. This firm may also utilise a future contract since it likes to have oil arrive every month and takes good care to plan. Based on the price specified in their future contract, the corporation will know the price at which they will get oil in this way. They are aware that after their contract expires, they will take over the oil deliveries.
Difference Between Future and Forward Contracts
Do you know which is the most popular forward contract in India? It is the dollar forward premia contract, which is used by most exporters and importers to hedge currency risk. In terms of the most popular futures contracts, it is the index futures and the stock futures traded on the equity segment of the NSE. Now let us tabulate some key points of differences between forwards and futures.
Particulars | Forward contracts | Futures contracts |
| How they operate | Forward contracts are over the counter (OTC) and hence they are not traded on the Exchanges. | Futures are exchange-traded contracts that are standardized and hence can be easily traded on the exchanges. |
| Contract specifications | Forwards are tailor-made contracts according to the unique needs of participants in a problem case. | Terms of the futures contract are largely standardized in terms of lot size, expires and underlying quality. |
| Counterparty risk | Forwards carry an element of counterparty risk, but now there are exchange guarantees on forwards too. However, forwards are normally with parties and institutions where there is a relationship of trust. | Clearing corporations of NSE and BSE act as the counterparty. Hence, the traders in exchange-traded futures don’t interface with each other, but they interface through the clearing corporation as the guarantor of trades. |
| Market liquidity | Forwards are low on liquidity unless there is another set of customers with similar profiles. That is why forward contracts are normally held till maturity. | Since futures are standardized, they are highly liquid. In the Indian context, the index futures and stock futures on major stocks have a high degree of liquidity and entry and exit is easy. |
| Price discovery | Is not efficient in the case of forwards. Since the forwards are between informed parties, the need for price discovery is not too high. | Standardization allows efficient price discovery for futures. Also, arbitrageurs and speculators add to the volumes and the liquidity in the markets. |
| Active in which markets | Forwards are more active in currency and commodity markets, where the need to customize contracts is a lot higher. | Exchange-traded futures are more common in stocks and indices but also exist in currencies and commodities and wherever they can be standardized. |
| Applications in practice | Forwards are normally used only when there is an underlying exposure for both parties. It does not make sense to create a customized contract to speculate. | Forward contracts support speculation and hedging. Normally, most of the commodity market hedging happens in forwards, although hedging via futures is also rapidly picking up. |
Key difference between Futures and Forwards
Apart from the fundamental differences mentioned above, some notable differences between Futures and Forwards are listed below.
Structure and Scope
A Futures Contract is subject to standardisation, and as a trader, you must make an initial margin payment. A Futures Contract, on the other hand, may be tailored to the needs of the trader and requires no upfront outlay.
Transaction Method
Futures contracts are traded on the stock exchange and are governed by the government. A Forward Contract, on the other hand, is arranged directly between the two parties without the intervention of any government-approved middleman.
Price Discovery Mechanism
Because a Futures Contract is standardised, it provides a more efficient price discovery method than a Forward Contract. Thus, the prices of a Futures Contract are transparent, but the pricing of a forward contract is opaque since it is dictated by two parties.
Risks Involved
When two parties sign an agreement, there is always the possibility that one of the parties may be unwilling to fulfil the terms at the moment of settlement. This risk is reduced in a Futures Contract since the stock exchange clearing house acts as both parties' counterparty. A forward contract, on the other hand, is settled at the time of delivery, and profit/loss may only be determined at that point.
Similarities between Future and Forward contracts
The following are some similarities between a forward contract and a future contract.
- Both agreements are derivative contracts.
- A future purchase or sale of derivatives is involved.
- These agreements aid in reducing risk and losses resulting from fluctuating prices.
- Both contracts rely on assumption strategies to fix the cost.
- The buyer and seller must complete the transaction on a certain date according to both of these contracts.
Conclusion
Now that you are aware of the difference between futures and forwards, you can start your investment path with clarity and confidence. However, you should be aware that making smart investment selections may be greatly aided by having a dependable and reputable financial partner like BlinkX offers expert guidance and a trading app for managing Demat accounts.
