Forwards and Futures are a type of financial contract, or we can say trading strategies in the stock market. 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 these trading strategies, one must know these differences.
Forwards and Futures – What Are They?
Before we detail the Forwards vs Futures differences, let’s understand what each of these strategies are:
- Forwards and Futures – What Are They?
- Forwards and Futures Differences
- 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 and the price are set at the time of entering the contract. Also, forward contracts are the counter (OTC) contracts, which means they do not trade on any established stock exchange.
Basically, such contracts help to offset fluctuations or volatility in the price of the underlying asset. For example, a chipmaker sells chips to a smartphone maker. Both are dependent on each other. Prices of chips may change going ahead or move in either direction. Thus, it could benefit one and not the other. Therefore, to save themselves from the fluctuations in prices, both chipmakers and smartphone makers fix the price for future supply now.
Futures Contracts or Futures are also very similar to the Forward contracts. It also includes an agreement to buy and sell an asset at a specific rate at some time in the future. The only major difference being they are standardized contracts that trade on the stock exchange.
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.
- Both are hedging strategies.
Forwards and Futures Differences
Following are the Forwards vs Futures differences that you need to know:
A futures contract is a standardized contract that trades on a futures exchange. A forward contract is a private agreement between two individuals or entities. Both types of contracts allow investors to buy and sell an underlying asset at a certain future date and at a specific price.
Type of Contract
A futures contract is a standardized contract, while the Forwards 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 it Trades?
Futures contracts trade on recognized stock exchanges. Forwards contact, on the other hand, trade OTC (over the counter). 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’s 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 forward contracts.
However, investors in futures are more vulnerable to the 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; there is no such risk.
Chances of Default
Since futures contracts trade on popular stock exchanges, the chances of default are almost negligible. Clearinghouses act as a guarantor in the futures market. On the other hand, forwards 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 forwards contract, the maturity is at a predetermined date, while maturity in a futures contract is as per the terms of the contract.
In the future, 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 s 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.
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.