Difference Between Futures and Forward Contracts
The main difference between futures and forward contracts is that forward contracts are traded over-the-counter and futures are exchanged in a futures market.3 min read
The main difference between futures and forward contracts is that forward contracts are traded over-the-counter (OTC) and futures are exchanged in a futures market.
Key Aspects of Futures Contracts
Futures contracts are uniform tools that are managed, using brokerage firms, to reserve a spot on whichever exchange deals with the given contract. These contracts agree to purchase or sell an asset on a determined future date at a specified price.
There are many terms that are consistent on futures contracts such as the following:
- Delivery places
- Technical details
- Trading and credit methods
When establishing a futures trade the two individuals or groups use their personal brokers to make the trade, just as they would during an ordinary stock trade. This means that investors are only able to trade if the futures contracts are accepted by both exchanges.
Comparing Futures and Forward Contracts
Unlike futures contracts which are standardized, forward contracts are completely tailored to the negotiating parties' terms in a private setting rather than a brokerage firm. Forward contracts can also be tied to any type of asset or object of value.
Additionally, the following terms are fully customizable by the respective parties in a forward contract:
- Settlement date
- Estimated amount of the contract
- Settlement type (cash or material)
When trading in a futures contract the following types of measures are required in seeking to minimize credit risk:
These measures develop a process in which the opposing parties trade payments of earnings or losses as they happen. The use of these marginal payments results in the market value of the futures contracts returning to zero at the end of each day. This ultimately removes any prospect of credit risk. The payments caused by margining can cause the price of futures to change resulting in differences between them and the related forward prices.
Forward contracts are exposed to both market and credit risk; however, earnings and loss are only acknowledged on the settlement date, so the credit risk will likely increase, rather than being minimized as they are in futures contracts.
Furthermore, forward contracts are only concerned with nonpayment by the opposite party if they fail to uphold the contract. In contrast, futures contracts risk nonpayment by the clearing house in which the exchange occurs.
Whatever the settlement price is on the last day of trading or the last day of the contract is the price at which futures contracts are paid. Whereas forward contracts are paid the price that was agreed upon at the time of the trade or the beginning of the contract.
Another difference between the two contracts is found in their jurisdiction. Futures contracts are usually held under government regulation based on its jurisdiction, forwards are typically regulated by the contractual dealings between the two individuals or groups.
The maturity dates of futures contracts can be set on the third Wednesday of any of the following months:
These are some more facts related to futures contracts:
- Currencies are limited
- Only one price occurs in the exchange
- Margin money is determined based on the amount established in the contract
- Daily settlement occurs often
- Only precise trades are permitted
If a forward contract involves a delivery, the person receiving the delivery is specified, whereas a futures contract chooses the person receiving the delivery at random.
As mentioned previously, cash flows are not present until settlement in a forward contract. Futures contracts, on the other hand, require marginal payments in an attempt to reduce risk.
The following are a few contrasting facts related to forward contracts:
- The price agreed upon by the two individuals or groups in the contract is the settled delivery price.
- Forward contracts are customizable; therefore, the amount and price of the given asset can vary with each contract.
- Forward contracts are informal and are therefore, not always enforceable.
- Forward contracts do not have a standard maturity date.
- The currencies of every country are accepted in a forward contract.
- There is no transactional limit for contract value.
- There is a difference between prices quoted for purchasing and prices quoted for selling.
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