Difference Between Futures and Forwards
- 19 Sept 2024
- By: BlinkX Research Team
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Futures and forwards are agreements between two partners to buy or sell a financial asset at a future set price. They work similarly but have some important differences. Futures contracts are standard, which means they have specific rules and are traded on exchanges. Futures contracts are more controlled and easier to use because they follow the same rules for everyone. On the other hand, forward contracts are made just between two people and are usually traded privately, so they are less controlled. Knowing these differences can help you pick the right contract for your needs. We will learn more about the difference between futures and forwards along with other essential aspects between forward contracts vs future contracts in this article.
Difference Between Future Contracts and Forward Contracts
Here’s a table highlighting the difference between futures and forwards.
Category | Forward Contract | Futures Contract |
| Meaning | A private agreement between two people to buy or sell something on a set date in the future at a specific price.
| A standardized contract to buy and sell an asset on a future date at a fixed price. |
| Standardization | Forward contracts are often customized to suit the parties' needs. | Futures contracts have set rules and fixed amounts to keep things consistent. |
| 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 does not need collateral because the two parties trust each other to keep the agreement. | A futures contract requires collateral. The parties need to deposit an initial margin. They must also maintain a minimum margin to cover potential losses. |
| Costs | Forward contracts usually have lower transaction costs. | Futures contracts can include costs like broker fees, exchange fees, and the need to keep a certain amount of money in the account as a margin. |
| Price determination | Forward contract prices are mutually agreed upon between the parties to the contract. | Futures contract prices are determined by open market forces |
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Table of Content
- Difference Between Future Contracts and Forward Contracts
- What is a Forward Contract?
- What is a Futures Contract?
- Similarities Between Futures vs Forwards Contracts
- Other Key Differences
- Conclusion
What is a Forward Contract?
A forward contract refers to a private deal between the two parties to purchase or sell an asset at a predetermined price and date in the future. Unlike futures contracts, which are traded on exchanges with standardized terms, forward contracts are created directly between the two parties. Therefore, these contracts can be tailored to meet the specific needs of both the buyer and the seller.
For instance, by using a forward contract, businesses can lock the price of raw materials or currencies to avoid changing prices. This enables them to predict expenses and sensitize costs. Forward contracts can also be used by investors to speculate on the direction of prices and try to make some profit.
What is a Futures Contract?
A futures contract is an agreement to buy or sell an asset, from commodities to stocks, at a set price on a future date. These contracts are standardized; they bear the same rules for all, right from the contract size through to the date of delivery and even to the quality of the asset. This standardization makes trading non-discriminatory and fair.
People use different futures contracts either for hedging or speculating purposes. Hedgers will be using the futures contracts to fix the price and not permit future changes, while the speculators try to make profits out of those price changes. This combination of users keeps on balancing the efficiency of the market.
Similarities Between Futures vs Forwards Contracts
Now, that you know the difference between forward and future contract, let’s also look at how they are similar. Although the two derivatives differ in many ways, they have some common aspects too. The following are some similarities between forwards vs futures contracts.
- 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 strategies to fix the cost.
- The buyer and seller must complete the transaction on a certain date according to both of these contracts.
Other Key Differences
Here are some other essential differences between forward and futures contracts based on different parameters.
- Structure: Futures contracts are standardized and follow set rules, traded on exchanges, which makes them more liquid and easier to buy or sell. Forward contracts, however, are customizable and can vary based on the agreement between the two parties. This customization makes them less liquid since they are private agreements.
- Risk: Futures contracts are less risky because they are regulated by exchanges, which manage the contracts daily and reduce the chance of default. Forward contracts, on the other hand, carry more risk as they are not regulated by an intermediary. This lack of regulation increases the likelihood of default and issues between the parties involved.
- Pricing: Futures contracts have a transparent pricing mechanism, which helps in discovering fair market prices. Forward contracts, however, have less transparent pricing since the terms are negotiated privately between the parties. This can result in less accurate pricing and inefficiencies.
Conclusion
A forward contract is customizable 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 utilize forward contracts to hedge their positions. Now that you understand the difference between futures and forwards, you may consider investing in them. Remember, a thorough knowledge of how these contracts work is quite essential. In addition, the risks involved should be properly analyzed before investing.
