Let us understand the difference between forward and future contract with an example. If a tomato grower and a ketchup factory want to enter into a tomato futures contract, it has to be a forward contract since it must be fully customized. The difference between futures and forwards arises from the need for customization versus standardization. The future vs forwards debate is essentially the debate of customization versus standardization.
Structurally, the forward contract meaning is the same as that of a futures contract meaning. Both are an agreement to buy or sell an asset at a future date at a price determined today. The only key difference is that forwards are customized and hence they are over-the-counter (OTC) products. On the other hand, futures are standardized and hence exchange traded products. Having understand what is future contract and what is forward contract as well as the future contract meaning, let us now move towards key forwards and futures differences.
As we stated earlier, the key difference between forward and future market is that the forward is customized and hence over the counter. The latter is standardized and hence exchange traded. In this segment, we shall look at in detail at the concept to future contract in derivatives and also at the forwards contracts in derivatives.
To sum up the story, forwards and futures are largely similar in structure and pay-offs, although the legal implications are different. Both, futures and forwards, entail 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. The only difference is that forwards are over the counter (OTC) contracts while futures are exchange traded contracts and hence standardized and also more secure.
What is a Forward Contract?
Usually, two parties engage into a forward contract because they have divergent opinions on what the future value of an item will be. One party wants to buy an item at a lower, specified price because they predict the price of that asset will increase in the future and they want to benefit from the price difference. This party thus proposes to be the buyer. The opposing side, on the other hand, hopes to limit their losses by locking in a predefined price since they predict that the asset's value will decline in the near future. Therefore, this party proposes to act as the vendor.
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 in order 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 due to the fact that it is impossible to predict the price per tonne for the upcoming year.
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What is a Future Contract?
A futures contract is a written agreement that specifies the sale and purchase of a certain good, asset, or security at a future price and time. Futures contracts are standardised to ensure quantity and quality to make trading on the futures exchange easier.
The underlying asset must be purchased and/or received by the futures contract buyer prior to the contract's expiration. The seller of this futures contract is responsible for providing and delivering the asset upon which it is based to the buyer at the time the futures contract is executed.
Futures contracts provide investors the chance to predict the future movement of the underlying assets, such as commodities, securities, or financial instruments. These contracts are frequently bought in an effort to protect losses from relatively adverse price swings by hedging the movements of the underlying asset's price.
For a better understanding, consider the following futures contract example:
Consider an oil producer that 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 ahead. On the basis of 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.
How Futures Differ from Forward Contracts
Do you know which is the most popular forwards 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 an exchange-traded contract which 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 to a problem case||Terms of the futures contract are largely standardized in terms of lot size, expiries 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 actually 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 profile. 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||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 it can be standardized|
|Applications in practice||Forwards are normally used only when there is an underlying exposure for both the parties. It does not make sense to create a customized contract to speculate||Forward contracts support speculation and also hedging. Normally, most of the commodity market hedging happens in forwards, although hedging via futures is also rapidly picking up|
Shortcomings and Challenges for Forward Markets
Having understood the concept of forwards, let us look at some of the limitations of forward contracts and how they are overcome by futures contracts.
- Forwards can be low on liquidity since it is hard to get secondary market participants for customized contracts. For instance, in the case of the forward contract between the tomato farmer and the ketchup factory, it would be tough for either party to exit unless another party with similar business requirements comes up. Forwards contracts are not standardized and that makes them less liquid. That is one of the biggest cases in favour of futures market trading.
- Since forwards are not listed or traded on exchanges, pricing is quite opaque and also arbitrary at most times. Here the larger participant has an undue advantage compared to the futures contracts which are more democratic. Also, this leaves out most retail investors from the purview of forward contracts. This also limits the scalability of such forwards contracts and they remain a very localized phenomenon.
- Forwards are vulnerable to counterparty risk. This risk arises if one of the party defaults. It could either be the buyer or the seller and if one of them defaults, the only recourse available to the aggrieved party is to take the legal route, which can be quite convoluted and long-winding. That problem is largely overcome in futures as the futures market has the clearing corporation counter guarantee. This ensures that even if there is a default, the exchange can draw upon its contingency fund and honour the defaulting side of the contract. The biggest advantage is that exchange traded futures are guaranteed by the clearing corporation and hence defaults are avoided since the clearing corporation takes over the defaulter’s liability. This has made the settlement process much smoother.
- Forward contracts are also subject to settlement and clearing complications since the settlement and clearing is done independently through professional clearing agents. However, nowadays, in many of the global markets forwards are also put through an organized exchange driven clearing and settlement mechanism to make the process flow smoother. In the case of the futures contracts, the clearing corporation affiliated to the stock exchanges acts as the central and objective referee in this case. The centralized trading platform of futures takes care of this.
However, forwards continue to exist in areas like commodities and banks where the participants are large institutions and hence chances of default are much less. For instance, the participants in the dollar forward market are institutions where the chance of default is very low. However, for the traders and hedgers at the retail and HNI / NII level, it is the futures trading market that eventually remains a more transparent and viable option.
Key Characteristics of a Futures Contract
Having understand the shortcomings of forwards, let us look at how futures contracts score as a product, largely because they are standardized and exchange traded.
- Like in case of forwards, futures are also an agreement to buy or sell an underlying. For every futures contract, there a buyer and a seller. It is just that the trading, settlement and clearing of futures is a lot more professional and process driven.
- Futures is a contract between two consenting parties through the exchange platform where the exchange acts as the centralized platform. To that extent, it is the same as forwards, except that in futures both the parties are anonymous to each other.
- The price of the futures is based on transparent price discovery mechanism and like stock prices, these futures prices are also discovered by demand and supply. Moreover, these prices are real time and the execution is visible in front of you.
- Futures are leveraged products and consequently margins are payable by both the buyer and the seller of the contract. In addition MTM margins are also payable if the price movement is unfavourable. However, if the price movement is favourable, then MTM credits are also available for trade.
- Quality and quantity of the contract are standardized in the case of futures. Quantity standardization happens in the form of lot sizes but quality standardization is more relevant to commodity futures since commodities are a lot more heterogeneous. There is also standardization of expiry and strike prices.
Similarities Between Future and Forward Contract
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.
Now that you are aware of the differences between a futures and a forwards contract, 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 user-friendly apps for managing demat accounts.
Frequently Asked Questions
The fundamental distinction between futures and forwards is how they are structured as contracts. Forwards are unconventional over-the-counter contracts that are made between parties that want to purchase or sell an asset at a specific price at a future date.
Traded on the exchanges are futures contracts, which are standardised contracts. Participants in futures trading are obligated to acquire or sell the underlying asset at a predetermined price and future date.
Hedging is done using both forward and futures contracts. However, futures are more often employed because of their standardisation, liquidity, and simplicity in offsetting market positions.
A forward contract has less liquidity, which is how they vary from future contracts.
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