Difference Between Forward Contract and Future Contract
Updated On Feb 02, 2024
If you're keen on investing with confidence, it's crucial to make sure you understand the finer details of various financial tools. And what better place to start than with forward contracts and future contracts? These are not just popular options amongst investors; they're powerful concepts when it comes to hedging, speculation, and risk management. So, grab a cup of your favourite beverage, and let's dive into an easy-to-understand exploration of the key differences between these two fascinating types of contracts.
Table of Contents
Meaning of Future Contract
A future contract is a standardised financial agreement traded on an exchange, where parties commit to buy or sell an asset at a predetermined price and a specific date in the future. These contracts are used to hedge against price fluctuations in various markets, including commodities, currencies, and indexes.
Key characteristics of a future contract include:
- Standardisation: Futures are standardised in terms of the quantity and quality of the asset, the delivery date, and the settlement procedures, ensuring uniformity across all contracts on the exchange.
- Exchange-Traded: Futures contracts are traded on organised exchanges. This trading platform provides liquidity, transparency, and regulatory oversight, reducing the risk of default by either party.
- Margin Requirements: Parties involved in futures contracts must deposit a margin, which is a fraction of the contract's value, to cover potential losses. This margin can be adjusted daily, based on market movements, in a process known as "marking to market."
- Settlement: Futures can be settled by physical delivery of the asset or through cash settlement, where the difference between the contract price and the market price at expiration is exchanged.
Future contracts are popular among investors for their liquidity, the ability to leverage, and the ease of taking both long and short positions. They are an essential tool for managing financial risks and speculating in various market conditions.
Meaning of Forward Contract
A forward contract is a customised financial agreement between two parties to buy or sell an asset at a specified future date for a price agreed upon today. Unlike futures, forward contracts are not traded on exchanges but are over-the-counter (OTC) agreements. They are widely used in various markets, including commodities and currencies, for hedging and risk management.
Key characteristics of a forward contract include:
- Customization: Forward contracts are tailored to the specific needs of the contracting parties. This means that the quantity, quality, delivery date, and other terms of the asset are negotiable and agreed upon by both parties.
- Over-the-Counter (OTC): These contracts are privately negotiated and traded directly between two parties, without the intermediation of an exchange. This provides flexibility but also adds to counterparty risk, as there is no centralised clearinghouse.
- No Margin Requirements: Since forward contracts are not marked to market like futures, there are usually no daily margin calls. The absence of a margin system can increase the risk of default.
- Settlement: Settlement in forward contracts typically occurs at the end of the contract term, either through physical delivery of the asset or cash settlement. The terms are determined at the inception of the contract.
- Risk and Regulation: Forward contracts involve higher counterparty risk as compared to futures. The OTC nature of these contracts means they are less regulated, leading to potential credit risk.
Forward contracts are particularly beneficial for companies looking to hedge specific risks tailored to their needs. They offer the flexibility to design contracts that closely align with the hedging requirements of the parties involved.
Future Contract vs Forward Contract
To clearly understand the distinctions between future contracts and forward contracts, let's compare their key attributes side by side:
|
Feature |
Future Contract |
Forward Contract |
|
Trading Venue |
Traded on organised exchanges. |
Traded over-the-counter (OTC), directly between parties. |
|
Standardisation |
Highly standardised in terms of contract size, quality, and delivery dates. |
Customised to the needs of the contracting parties. |
|
Regulation |
Subject to regulatory oversight and exchange rules. |
Less regulated, primarily governed by the terms agreed upon by the parties. |
|
Counterparty Risk |
Lower, due to the presence of a clearinghouse and margin requirements. |
Higher, as there is no intermediary guaranteeing the transaction. |
|
Margin Requirements |
Requires initial and maintenance margins. Daily settlement of gains and losses ("marking to market"). |
No margin requirements. Settlement occurs at the end of the contract term. |
|
Liquidity |
Generally high, due to trading on an exchange. |
Depends on the agreement between parties; generally lower than futures. |
|
Settlement Method |
Can be settled by physical delivery or cash settlement. |
Typically settled by physical delivery, though cash settlement can be agreed upon. |
|
Flexibility |
Less flexible, due to standardisation. |
More flexible, can be tailored to specific needs. |
|
Purpose |
Used for hedging, speculation, and arbitrage. |
Primarily used for hedging specific risks. |
|
Suitability |
Suitable for investors and traders seeking liquidity and price transparency. |
Suitable for businesses and individuals seeking to hedge specific exposures with tailored terms. |
Now that you know the nitty-gritties of forward contract vs future contract, let’s move on to the similarities.
Similarities Between Future and Forward Contracts
While future and forward contracts have distinct differences, they also share several similarities. Understanding these commonalities is crucial for comprehending the broader context of these financial instruments. Here are the key similarities:
|
Aspect |
Details |
|
Risk Management Tool |
Used for hedging risks associated with price fluctuations, allowing businesses and investors to lock in prices |
|
Contractual Agreement |
Agreement to buy or sell an asset at a predetermined price on a future date |
|
Uses: Speculation and Hedging |
Utilised by speculators to bet on price movements for profits, and by hedgers to protect against adverse price movements |
|
Underlying Asset |
Involves commodities, currencies, financial instruments, or other assets; value derived from these assets' price movements |
|
Settlement Date |
Settled at a future date, could involve physical delivery or cash settlement |
|
Price Movement Exposure |
Parties are exposed to risks and rewards of price movements in the underlying asset |
|
Upfront Cost |
No upfront cost for creating the contract (excluding margins for futures); profit or loss realised at settlement |
|
Contract Termination |
Can be terminated before expiry, through offsetting position (futures) or mutual agreement (forwards) |
Understanding these similarities provides a holistic view of how future and forward contracts function in the financial markets and their role in risk management and investment strategies.
Final Thoughts
Understanding the future and forward contracts is essential for anyone involved in finance, whether it's for hedging risks, speculating, or simply enhancing one's financial knowledge. While these instruments differ in terms of standardisation, trading venues, and risk profiles, they share the common purpose of managing price risks and offering opportunities for strategic financial planning. Recognising when to use futures or forwards can make a significant difference in the outcomes of financial endeavours.
FAQs
- What are future contracts?
Future contracts are standardised agreements traded on exchanges to buy or sell an asset at a predetermined price and date.
- What are forward contracts?
Forward contracts are customised agreements between two parties to buy or sell an asset at a specific future date and price, traded over-the-counter.
- How do futures and forwards manage risk?
Both are used to hedge against price fluctuations in the market, allowing parties to lock in prices and manage risk.
- Are future contracts standardised?
Yes, futures are highly standardised in terms of contract size, quality, and delivery dates.
- Can forward contracts be customised?
Yes, forwards are customised to meet the specific needs of the contracting parties.
- What is the main risk in forward contracts?
The main risk is counterparty risk, as there is no central clearinghouse to guarantee the transaction.
- Do future contracts require a margin?
Yes, futures require an initial and maintenance margin, with daily settlement of gains and losses.
- Can forward contracts be traded on exchanges?
No, forward contracts are traded over-the-counter, not on exchanges.
- Which is more liquid, futures or forwards?
Futures are generally more liquid due to trading on exchanges.
- Are both futures and forwards used for speculation?
Yes, both can be used for speculation and hedging, though futures are more commonly used for speculation due to their liquidity and standardisation.
