Differences between forwards and futures

2023-12-15 21:59:04

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. Although both allow traders to trade in the future, there are many differences between Forwards and Futures. To understand the importance and use of these two trading strategies, one must know these differences.

Forwards and futures: what are they?

Before detailing the differences between Forwards and Futures, let’s understand what each of these strategies consists of:

Forward contracts are an agreement between two private parties to buy and sell an asset at a future date and at a specific price. Both the date and the price are set at the time the contract is concluded. Additionally, forward contracts are over-the-counter (OTC) contracts, meaning they are not traded on any established stock exchange.

Basically, such contracts help offset fluctuations or volatility in the price of the underlying asset. For example, a chip manufacturer sells chips to a smartphone manufacturer. They are both dependent on each other. Token prices may change in the future or move in any direction. Therefore, it could benefit one and not the other. Therefore, to save themselves from price fluctuations, both chip and smartphone makers now price future supply.

Futures or Futures Contracts are also very similar to 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 is that they are standardized contracts that are traded on the stock exchange.

The following are the similarities between forward 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.

Differences between forward and future

The following are the differences of Forwards vs Futures that you need to know:

Meaning

A futures contract is a standardized contract that is traded on a futures exchange. A forward contract is a private agreement between two people or entities. Both types of contracts allow investors to buy and sell an underlying asset at a specific future date and at a specific price.

Type of contract

A futures contract is a standardized contract, while a forward contract is a customized or tailored contract. Since forward contracts are tailor-made, buyers and sellers can negotiate the terms of the agreement.

Where is it negotiated?

Futures contracts are traded on recognized stock exchanges. The forwarding contact, on the other hand, operates OTC (over the counter). Or we can say that there is no secondary market.

Transaction method

A futures contract has standard terms and is therefore listed and traded on the exchange. On the other hand, buyers and sellers directly negotiate the terms of a forward contract.

Settlement

The settlement of Future contracts is daily, while for the forward contract it is on the expiration date. Futures contracts are quoted to market, meaning that settlement of profits or losses occurs daily.

Risk

In case of futures contract, the risk factor is low, while the risk factor is high in futures contract as the agreement is private between two parties. Therefore, there is counterparty risk in forward contracts.

However, futures investors are more vulnerable to fluctuations in the prices of the underlying asset since settlement is daily. In a forward contract, there is no exchange of cash until maturity; there is no such risk.

Chances of non-compliance

Since futures contracts are traded on popular stock exchanges, the chances of default are almost negligible. Clearing houses act as guarantor in the futures market. On the other hand, forward contracts are private agreements. Therefore, the probability of default is higher.

Contract size

In the futures market, contracts are standardized. Therefore, the contract size is fixed. However, in the forward market, the contract size varies depending on the terms of the contract.

Warranty need

In futures contracts, traders must put up initial margin, while there are no collateral requirements in a forward contract.

Maturity

For a forward contract, expiration is on a predetermined date, while expiration in a futures contract is according to the terms of the contract.

Prices

In the future, the contract price returns to zero at the end of the day. However, in the forward market, the contract becomes more or less valuable over time. Therefore, the price of a futures contract and a forward contract with the same expiration and strike price would be different.

Price transparency

There is price transparency in the futures market. But, in the forward market, the price is only known to the trading parties.

Who regulates?

Since futures contracts are traded on popular stock exchanges, they are regulated by the stock exchange. The forward contract, on the other hand, is self-regulated.

Liquidity

Liquidity is high in the futures market, while in the forward market, liquidity is low. Since liquidity is high in the futures market, investors can come and go as they wish.

Close the contract

To close a futures contract, the buyer or seller must enter into a second contract, which must be the exact opposite of the original contract. There are two ways to close a position in the forward 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 speculative purposes. On the other hand, forward contracts serve both hedging and speculation purposes.

Last words

It will not be wrong to say that the liquidity in the futures market makes it better than the futures market. Furthermore, transparency and regulations in the futures market make it less risky and safer for investors.