Forward Contracts vs. Futures Contracts: Key Differences

Last Updated: 19 Nov 2024

Introduction

Forward and future contracts are financial agreements that include two parties, who accept to purchase or sell a particular asset at a predetermined price by a particular date in the forthcoming time. Sellers and buyers can lower their risks of any price modification by sealing the cost beforehand.

A forward contract is done over the counter (OTC) and it is settled upon the termination of the contract. The parties negotiate the terms of the contract privately. However, forwards have a risk default since there is a chance that the other party will not come up with the amount or goods to be provided.

A future contract is a standarised trade on the stock exchange. They are settled on a day-to-day basis. This arrangement has a fixed maturity period with uniform terms. It has comparatively less risk since it is certified that payments will be made on an agreed date.

It is important to understand the difference between forward and future contracts, especially for traders who are involved in the buying and selling of assets.

Understanding Futures Contract

A future contract is the agreement to buy or sell assets at a specified rate on a future date. The daily changes in the contract are settled every day on a market-to-market basis. The liquidity of the futures market gives investors the ability to step in or step out as per their own comfort.

This contract is used a lot by investors who are looking for profits from the moving price of an asset. They usually shut the contract before its maturity which results in no delivery happening. In such an instance, the settlement takes place by cash usually.

The trades take place through exchanges. Clearing houses and exchange partners play the role of counter-party when a futures purchase is made through a broker. This results in a sharp decline in default chances. According to a study, futures that were traded the most were:-

1. Agriculture
2. Currencies
3. Energy
4. Equities
5. Interest Rates
6. Metals

Futures Contract Example

Oil producers deal with futures as it helps to lock a price. They ensure the delivery is made after the expiry date passes. For example – A company is scared that their demand would slow down leading to a drop in market prices of oil and having an impact on the company heavily. The company would enter into a futures contract that would lock the price of oil at a rate of ₹6300 for 1 barrel. This would be sealed in the hope of a price decline in six months.

If the demand decreases and prices drop to ₹5485 for a barrel, A company would still be eligible for the initial amount of ₹6300 for 1 barrel. This would give a profit of ₹815 for each barrel. However, in case the oil prices shoot up to ₹7175 per barrel, A company will lose the ₹815 profit. This would still safeguard them from a financial crunch even if the oil prices plummet drastically.

Understanding Forward Contract

A forward contract is a personally negotiated contract that is made between buyers and sellers of assets. It is set at a future date and the price is pre-decided. No trading takes place on an exchange, having relatively adjustable terms and conditions. This includes the price of the underlying asset and the mode through which it will be delivered. The end of the contract marks the settlement date for forward contracts.

Multiple risk managers utilise forward contracts to cut down upon the volatile abilities of an asset’s value. Forward contracts do not see fluctuations since the terms are pre-decided on execution. This means – if an agreement is made upon the sale of 1kg of gold at the rate of ₹7165 per gram (i.e 71,65,000 for a kg), then the conditions of sale cannot change irrespective of a hike or drop in the price of gold in the market.

Forward Contract vs Futures Contract

Understanding forward contract vs future contract might be a tough task initially. Here is a table simplifying the difference between forward and future contracts.

 

Aspect	Forward Contracts	Future Contracts
Traded	Over-the-counter	On listed trades
Terms	Modifiable	Standard
Costs	Nothing upfront	To be paid with a starting margin
Counterparty risk	Risky	Low-Risk

Forward Contract Example

Here is an example of how future contracts function.

For example, a publisher has a huge supply of books. Their concern is the value of their commodity would drop soon. To avoid this risk, the publisher negotiates with a financial institution. Say a deal of giving 100 books at the rate of ₹100 per book for six months is made. The parties have agreed to settle contracts in cash.

The result of this contract for books could differ in these ways:

1. The future rate is precisely as contracted. The agreement is settled as per the contract with no party owing any money to each other.
2. The future price turns out to be lower than the negotiated price. For example – the price drops to ₹70 per book, but the settlement amount still stays the same.
3. The future price is higher than the rate agreed upon. The agreement is settled at the negotiated price, despite the producer gaining a higher amount per book.

Other Key Differences

Forward contracts are made subtly between two parties over the counter and settlement dates and what’s exchanged at maturity are chosen, not stamped to market. Since the forward contract is organised between two counterparties, there is the chance that one of them may default and not fulfil the agreement’s terms. This is known as a counterparty hazard.

A futures contract is a settled contract exchanged on a prospects trade which has edge prerequisites that back up the futures contract. It disposes of probabilities of counterparty hazard. Futures contracts are exchanged when the trade is open and can be stamped to market in real-time. What futures and forwards have in common is the capacity to lock in a set cost, sum amount, and termination date for the trade of the fundamental resource.

Frequently Asked Questions

How does an option differ from a forward or futures contract?

Here is the difference between forward and future contracts. A forward contract is a customised agreement between two parties to buy/sell an asset at a future date, without standarisation. In contrast, the future contract is standardised and traded on exchanges. Future contract offers more liquidity and less counterparty risk due to market regulation.

What is an advantage of a forward contract over a futures contract?

A forward contract gives customization options in its terms and conditions. This allows parties to hand-pick their needs to be specified in the contract. This flexible nature stands as an upper hand to the forward contract being the difference between forward and future contracts.

What is the key difference between forward and future contracts?

The main distinction between forward contract vs future contracts is their trading platforms and customization. Forward contracts are private, customizable deals between parties, while future contracts are standardised and traded on regulated exchanges. Thus, the difference between a forward and future contract is in standarisation and trading environment.

What are the differences in the pricing of forwards and futures?

Forward contract pricing is usually formed on the spot price of the underlying asset, adding a premium for risk. On the contrary, future contract pricing includes daily mark-to-market adjustments. This makes the pricing of forwards and futures different in their risk handling and fluctuations of price.