Difference Between Forward And Futures Contract

If you want to create a robust investment portfolio, you should be aware of the important trading techniques and strategies. A key segment of the financial markets is derivatives trading. The amount of money involved in derivative trade, across the globe, is mind-boggling, and some experts believe that the total money involved in derivative trade is actually more than the actual money available in the world. Warren Buffet remarked that derivatives were dangerous, though not evil per-se.

Fundamentally, derivative trading is conducted on the basis of the price movement of the derivative product’s underlying asset. These assets could be stocks, currencies, bonds, commodities, and so on. There are two types of derivative trading: standardised financial contracts with a stock exchange as a counter-party, and private contracts between parties, without the involvement of a formal intermediary. While the former is known as Exchange Traded Funds, the latter is called Over the Counter (OTC) derivative trading.

Both the types of derivative trading have their distinct features and benefits. Here, you must understand the nature of financial contracts regarding both the types. While essentially both ETFs and OTC derivatives involve agreement between the parties to purchase and sell the underlying asset on a future date at the specified price, a future contract is part of ETF trading, while a forward contract pertains to OTC derivative trading.

What Is a Future Contract?

A future contract, also known as futures, is a standardised financial contract, which is traded through stock exchanges. In a futures contract, the standardised terms and conditions include:

  • Volume of trade.
  • Delivery date.
  • Credit procedure.
  • Other technical specifications.

An example of a futures contract is currency futures, known as FX Future. Using a futures contract on currency rate, you can exchange one currency with another on a given date in future, at the currency rate, which is fixed on the date of the purchase. In India, you can use the future contracts on four pairs of currencies: Indian Rupee and US Dollar, Indian Rupee and United Kingdom Pound Sterling, Indian Rupee and Euro and Indian Rupee and Japanese Yen. You can also use future contracts to trade in other segments, like commodities and stocks.

What Is a Forward Contract?

A forward contact, also known as forwards, is a private agreement between two parties to purchase or sell the underlying asset at a predetermined time at a specific price. Any forward contract is subject to both market risk and credit risk. You can know about the profit or loss accruing from a forward contract only at the date of settlement of the contract. You can have a forwards contract for trading in different OTC derivatives, such as stocks, commodities, and so on. It can provide you with a greater flexibility with the terms of trade. For instance, in India you can have a forward contract for currencies, which are outside the specified list by stock exchanges.

Difference Between Forward And Future Contract

You can refer to the chart given below to understand the key differences between the two contracts

Future Contract Forward Contract
Settlement On a daily basis by the stock exchange. On the maturity date as negotiated between the parties.
Regulation Regulated by market regulators such as the Stock Exchange Board of India (SEBI). Self-regulated.
Collateral Margin requirements as per the stock exchange rules. Zero requirement of initial margin
Maturity On a predetermined date. According to the terms of the private contract.

Now here is a look at the other important differences between future and forward contracts:

Structure, Scope And Purpose

A futures contract is subject to standardization and uniformity, besides the requirement of margin payments. Conversely, the terms of trade are flexible in a forward contract, and can be negotiated to fit the requirements of the trading parties. While futures are highly liquid, forwards are typically illiquid, or low on liquidity. ETF Futures are typically more active in segments, like stocks, indices, currencies and commodities, while OTC Forwards usually sees larger participation in currency and commodity segments.

Transaction Method

While a future contract is regulated by the framework or rules provided by the government, a forward contract is directly negotiated between the buyer and the seller, without the involvement of any government-approved intermediary. Future contracts are ETF contracts, thereby implying the requirement of being quoted and traded via stock exchanges, while futures contracts are essentially over the counter contracts.

Price Discovery Mechanism/Pricing

The in-built feature of standardization allows for an efficient price discovery mechanism for future contracts, while the absence of a centralized framework allows for an inefficient price discovery mechanism for forward contracts, in a completely informal market. While the price of futures is transparent, forwards have opaque and arbitrary pricing.

Risks Involved

Forwards are subject to counter-party risks. This is a type of risk accruing from the very nature of the private terms and agreements, that are negotiated. For instance, one of the parties can refuse to honour the terms of the agreement at the time of settlement. Besides, the forward contracts are also subject to default risk, in the case of the trading party not settling the dues on the specified date. Future contracts, however, don't pose any counter-party risks because the stock exchange acts as a counter-party for all parties. Alongside, all the market positions are recorded by the stock exchange after the end of the daily trading session, known as Marked-to-Market settlement. As the trading parties are bound by the terms of the contract - through the stock exchange - there is no risk of default in payment on the maturity date.

Conclusion

After knowing the difference between future and forward, you can now commence your investment journey with clarity and confidence. You should also remember that a trusted and reliable financial partner can play a key role in ensuring that you make wise investment decisions. Remember, a reputed broking firm can provide you manifold advantages such as zero Demat and trading account opening fees, zero Demat AMC for one-year, free brokerage for a month, cutting-edge trading platforms and mobile apps and a single account for all investment options.

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