WHAT IS THEDIFFERENCE BETWEEN FORWARD CONTRACTS AND FUTURE CONTRACTS

Forward Contracts vs. Futures Contracts: An Overview

Forward and futures contracts are derivatives arrangements that involve two parties who agree to buy or sell a specific asset at a set price by a certain date in the future. Buyers and sellers can mitigate the risks associated with price movements down the road by locking in the purchase/sale price in advance.

A forward contract is an arrangement that is made over-the-counter (OTC) and settles just once at the end of the contract. Both parties involved in the agreement negotiate the exact terms of the contract. It is privately negotiated and comes with a degree of default risk since the counterparty is responsible for remitting payment.

Futures contracts, on the other hand, are standardized contracts that trade on stock exchanges. As such, they are settled on a daily basis. These arrangements come with fixed maturity dates and uniform terms. There is very little risk with futures, as they guarantee payment on the agreed-upon date.

Forward Contracts

The forward contract is a privately-negotiated agreement between a buyer and seller to trade an asset at a future date at a specified price. As such, they don't trade on an exchange. Because of the nature of the contract, forward contracts have more flexible terms and conditions, including the number of units of the underlying asset and what exactly will be delivered, among other factors. Forwards have one settlement date: the end of the contract.

Many hedgers use forward contracts to cut down on the volatility of an asset's price. Since the terms are set when it is executed, a forward contract is not subject to price fluctuations. That means if two parties agree to the sale of 1,000 ears of corn at $1 each (for a total of $1,000), the terms cannot change even if the price of corn goes down to 50 cents per ear. It also ensures that delivery of the asset or cash settlement (if specified) will take place.

Because of the nature of these contracts, forwards are not readily available to retail investors. The market for them is often hard to predict. That's because the agreements and their details are generally kept between the buyer and seller, and are not made public. Since they are private agreements, there is a high degree of counterparty risk, which means there may be a chance that one party will default.

Futures Contracts

Like forwards, futures contracts involve the agreement to buy and sell an asset at a specific price at a future date. The futures contract, however, has some differences from the forward contract. These contracts are marked-to-market (MTM) daily, which means that daily changes are settled day by day until the end of the contract. The futures market is highly liquid, giving investors the ability to enter and exit whenever they choose to do so.

These contracts are frequently used by speculators, who bet on the direction in which an asset's price will move, they are usually closed out prior to maturity and delivery usually never happens. In this case, a cash settlement usually takes place.

Because they are traded on an exchange, they have clearing houses that guarantee the transactions. This drastically lowers the probability of default to almost never. Contracts are available on stock exchange indexes, commodities, and currencies. The most popular assets for futures contracts include crops like wheat and corn, and oil and gas.

Key Differences

One of the things that set forward contracts from futures contracts is how they're regulated. Forward contracts aren't regulated at all while futures are overseen by a central government body. The agency that provides oversight and regulation of futures contracts is the Commodity Futures Trading Commission (CFTC). The CFTC was established in 1974 to regulate the derivatives market, to ensure the markets run efficiently, and to protect the interests of investors by preventing fraud and manipulation.

Guarantees for each contract are also provided by different parties. Since forwards are privately negotiated, they provide the guarantee to settle the contract. Futures, on the other hand, have an institutional guarantee provided by the clearinghouses that back them. Unlike forwards, where there is no guarantee until the contract settles, futures require a deposit or margin. This acts as collateral to cover the risk of default.