Difference between Forward Contract and Future Contract
What is forward contract and future contract with examples?
Forward Contract is a private agreement between two parties where one party agrees to buy and sell the underlying asset or commodity at a specified price on a specific future date. In simple words, we can say that a forward contract is one of the simplest forms of derivatives where the contract value depends on the spot or market price of the underlying asset.
A future contract is a contract generally made on the trading floor of the future in which the parties agree to exchange the asset for cash at a fixed price and at a future specified date. A futures contract is standardized in terms of the quantity, date, and delivery of the item.
What is the difference between forward contract and future contract?
Forward contracts and futures contracts are both financial derivatives used for hedging and speculation in the financial markets. A forward contract is a customized agreement between two parties to buy or sell an asset (such as a commodity, currency, or financial instrument) at a specified price on a future date. These contracts are typically private and not traded on an exchange.
A futures contract is a standardized agreement between two parties to buy or sell a specified quantity of an asset at a predetermined price on a specific future date. Futures contracts are standardized and traded on organized exchanges.
Forward contracts are highly customizable and can be tailored to the specific needs of the parties involved. The terms, such as quantity, price, and delivery date, are negotiated between the buyer and seller.
Futures contracts are standardized with fixed contract sizes, expiration dates, and delivery terms. These standards are set by the exchange, making them more uniform and easier to trade.
Forward contracts are typically traded over-the-counter (OTC), which means they are privately negotiated between two parties. There is no centralized exchange, and the terms of the contract can vary widely.
Futures contracts are traded on organized exchanges, such as the Chicago Mercantile Exchange (CME) or the Intercontinental Exchange (ICE). The exchange acts as an intermediary, guaranteeing the performance of the contract, and provides a centralized marketplace for trading.
In a forward contract, there is a higher degree of counterparty risk because the contract is a private agreement between two parties. If one party fails to meet its obligations, the other party may face significant risk.
Futures contracts are subject to less counterparty risk because the exchange acts as the intermediary and guarantees the performance of the contract. Traders on the exchange do not need to worry about the creditworthiness of their trading counterparties.
Liquidity in forward contracts can vary significantly, and it may be more challenging to find a willing counterparty for a specific contract.
Futures contracts are generally more liquid due to their standardized nature and trading on organized exchanges. Traders can easily enter and exit positions.
Forward contracts are not marked to market daily. Profits and losses are realized only upon contract maturity when the final settlement occurs.
Futures contracts are marked to market daily. The gains and losses are settled daily, with profits and losses being transferred between the parties’ accounts based on the contract’s daily price movements.
Forward contracts offer greater flexibility in terms of contract terms and customization, making them suitable for specific hedging needs.
Futures contracts are less flexible because they are standardized. They may not perfectly align with the specific needs of every trader or hedger.
S.No. | Forward Contract | Future Contract |
| 1. | Forward Contract is an agreement between two parties to buy and sell the underlying asset at a certain price on a future date. | A futures contract is a binding contract whereby the parties agree to buy and sell the asset at a fixed price and a future specified date. |
| 2. | A forward contract is a tailor-made contract which means they are customized according to the needs of the client. | A futures contract is a standardized contract where the conditions relating to quantity, date, and delivery are standardized. |
| 3. | In the case of Forwarding contract, there is a high counterparty risk as compared to a futures contract. | In the case of Future contracts,there is a low counterparty risk as compared to a forward contract. |
| 4. | Forward contracts generally mature by delivering the commodity. | Future contracts may not necessarily mature by delivery of the commodity |
| 5. | There is no requirement of collateral in the case of the forward contract. | Some amount of initial margin is required in case of future contracts. |
| 6. | Swap transactions are allowed in a forward contract. | Only direct transactions are allowed in the futures contract |
| 7. | The purpose of the forward contract is to prevent loss through hedging. | The purpose of futures contracts is mainly to have speculative gain. |
| 8. | A forward contract is traded on Over the Counter (OTC) i.e. there is no secondary market for such contracts. | Futures Contracts are traded on an organized securities exchange. |
| 9. | Forward contracts are settled on a maturity date ie; at the end of the contract. | Future contracts are settled on a daily basis, i.e. the profit or losses are settled daily. |
| 10. | Forward contracts are self-regulated. | Futures contracts are regulated by the securities exchange. |
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