Difference Between Futures and Forwards
- 18 Jul 2024
- By: BlinkX Research Team
Derivatives such as forward and futures contracts include two parties that have a mutual agreement to buy or sell a particular asset at a predetermined price on a future date. This allows them to reduce the risk of price fluctuations. Conversely, futures contracts are standardised for trading on stock exchanges. Thus, they are settled every day. These agreements have consistent conditions and set maturity dates. Because they ensure payment by the scheduled date, they have far less counterparty. Let’s understand the difference between a forward contract vs future contract in this article.
What is a Forward Contract?
Forwards are agreements between two parties to buy/sell the underlying asset at a certain price over a predetermined period. They 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 take an example to understand forward contracts better. Assume a farmer will harvest 20 tonnes of corn in a 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. So, the farmer can enter into a forward contract with a buyer. It will fix the price at which the farmer can sell the corn next year, regardless of the market price at that time.
Table of Content
- What is a Forward Contract?
- What is Futures Contract?
- Difference Between Future Contracts and Forward Contracts
- Similarities Between Future and Forward Contracts
What is Futures Contract?
It is a standardised financial contract in which a quantity and price are specified, and the payment is made at a future date. 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 have the legal obligation 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 guarantee that the oil producer receives the set price and avoids a loss. The oil producer can lock in the price at which the oil will be sold to the buyer after the future contract expires.
On the other hand, a manufacturing firm could need oil to produce widgets. This firm may also use a future contract since it may want to have oil arrive every month. 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 Contracts and Forward Contracts
Here’s a table highlighting the key differences between forwards vs futures contracts.
Category | Forward Contract | Futures Contract |
Meaning | A private agreement between two parties to buy or sell an underlying asset on a future date at a fixed price. | A standardised contract to buy and sell an asset on a future date at a fixed price. |
Standardisation | Forward contracts are often customised to suit the parties' needs. | Futures contracts have standardised terms for consistency and pre-defined lot sizes. |
Liquidity and Transparency | Forward contracts lack transparency and liquidity, being private agreements. | Futures contracts are very liquid and exchanged on exchanges, which ensures transparency. |
Risk | Forward contracts have higher counterparty risk. | Future contracts have lower counterparty risks. |
Settlement | Forward contracts are settled at the maturity date and are settled in cash or physical settlement. | Forward contracts are settled on their maturity date, either in cash or physically. |
Margin | A forward contract has no collateral requirement, as the parties trust each other to honour the contract. | A futures contract contains a collateral requirement, since the parties must deposit an initial margin and keep a maintenance margin to protect losses. |
Costs | Forward contracts usually have lower transaction costs. | Futures contracts may involve brokerage, exchange fees, and margin requirements. |
Price determination | Forward contract prices are mutually agreed upon between the parties to the contract. | Futures contract prices are determined by open market forces. |
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
A forward contract is customisable since both parties may choose the price, date, and contract parameters at their leisure. The counterparty risks are considerable since the two parties make a legal agreement via a stockbroker, and the transaction is also not executed on an exchange. This is why traders and investors regularly utilise forward contracts to hedge their positions. Now that you understand the distinction between forward and future contracts, you may consider investing in them. Remember, a thorough knowledge of how these contracts work is quite essential. In addition, properly analyse the risks involved before investing.
