Forwards and Futures are a type of derivatives contract which derives their value from the performance of underlying assets. Both types of contracts allow the trader to buy or sell a certain asset at a certain price in the future. Though both allow the traders to trade in the future, there are many forwards vs futures differences. To understand the importance and use of both, one must know these differences.
Forwards vs Futures Differences
Following are the Forwards vs Futures differences that you need to know:
- Forwards vs Futures Differences
- Similarities between Forwards & Futures
- Final Words
Forwards contracts are an agreement between two private parties to buy and sell an asset at a date in the future and at a specific price. Both, the date of buying or selling and the price are set at the time of entering the contract. Also, forward contracts are over-the-counter (OTC) contracts, which means they do not trade on any established stock exchange. These work in accordance with the needs of counterparties, enabling customization of contracts such as the delivery date and so on.
Futures Contracts or Futures are also very similar to forward contracts. It also includes an agreement to buy and sell an asset at a pre-defined specific rate at some time in the future. The only major difference being they are standardized contracts that trade on the stock exchange.
Type of Contract
A futures contract is a standardized contract, while the forward contract is a customized or tailor-made contract. Since forward contracts are tailor-made, buyers and sellers can negotiate the terms of the agreement.
Where do these Trades?
Futures contracts trade on recognized stock exchanges also known as exchange-traded markets. Forwards contact, on the other hand, trades in the (OTC) over-the-counter market. Or, we can say there is no secondary market.
A futures contract has standard terms and, thus, is quoted and traded on the exchange. On the other hand, buyers and sellers directly negotiate the terms in a forward contract.
Settlement on futures contracts is on a daily basis, while for the forward contract, it is on the maturity date. Futures contracts are marked to market, meaning settlement of profit or loss is on a daily basis.
In the case of the futures contract, the risk factor is low, while the risk factor is high in the forward’s contract as the agreement is private between two parties. Thus, there is counterparty risk in the forward contracts.
However, investors in futures are more vulnerable to fluctuations in the prices of the underlying asset as the settlement is on a daily basis. In a forward contract, there is no cash exchange until maturity.
Chances of Default
Since futures contracts trade on popular stock exchanges, the chances of default are almost negligible. Clearing houses act as a guarantor in the futures market. On the other hand, forward contracts are private agreements. Thus the probability of default is more.
Size of Contract
In the futures market, the contracts are standardized. Therefore, the size of the contract is fixed. However, in the forwards market, the size of the contract varies on the basis of contract terms.
Need of Collateral
In futures contracts, traders need to put an initial margin, while there is no requirement of collateral in a forwards contract.
For a forward contract, the maturity is at a predetermined date, while maturity in a futures contract is as per the terms of the contract.
In a futures contract, the price of the contract resets to zero at the end of the day. However, in the forwards market, the contract gets more or less valuable over time. Thus, the price of a futures and forward contract with the same maturity and strike price would be different.
There is price transparency in the futures market. But, in the forwards market, the price is only known to the trading parties.
Since futures contracts trade on popular stock exchanges, they are regulated by the stock exchange. Forwards contract, on the other hand, is self-regulated.
Liquidity is high in the futures market, while in the forwards market, liquidity is low. Since liquidity is high in the futures market, investors can enter and exit whenever they want.
Closing the Contract
To close a futures contract, the buyer or seller needs to make a second contract, which should be the exact opposite of the original contract. There are two ways to close a position in the forwards market, first, by selling the contract to a third party, and second by entering into another contract, which is the exact opposite of the first.
Suitable for Hedging or Speculation
Traders can use futures contracts for speculation purposes. On the other hand, forward contracts serve both hedging and speculation purposes.
Similarities between Forwards & Futures
Following are the similarities between Forwards and Futures contracts:
- Both contracts are an agreement to buy and sell assets.
- The agreement is for a future date.
- Prices are derived from the underlying assets.
- The two most popular uses of future and forward contracts are- hedging and speculation.
To summarize, both forwards and futures contracts entail buying and selling a commodity or financial instrument at a specific time and price. Futures contracts are standardized contracts traded on an exchange. Whereas forwards private bilateral contracts between two parties, agreeing to exchange a commodity or asset at a specified future price. In forward contracts, there is always a risk of default. On the contrary, future contracts have a clearing house that guarantees the transaction and eliminates the default risk—settlement of the forward contract end at the specified date. It won’t be wrong to say that liquidity in the futures market makes it better than the forwards market. Also, transparency and regulations in the futures market make it less risky and more secure for investors.