Difference between future and forward contracts, Future Contracts, Forward Contracts

Difference between future and forward contracts

In this article, we are going to discuss about Difference between future and forward contracts. Before learning difference between future and forward contracts, you must be familiar with the meaning of Future Contracts and Forward Contracts.

Future Contracts Meaning

A futures contract is simply a legal agreement between two parties to buy or sell an asset at a certain time in the future at a predetermined price.

There are two parties to every futures contract – the seller of the contract, who agrees to deliver the asset at the specified time in the future, and the buyer of the contract, who agrees to pay a fixed price and took delivery of the asset.

Futures contract are mainly used for hedging but change in prices of the underlying asset of the future contract provide gains to one party at the expense of the other.

The futures contracts are standardized and exchange traded. To facilitate liquidity in the futures contracts, the exchange specifies certain standard features of the contract. It is a standardized contract with standard underlying instrument, a standard quantity and quality of the underlying instrument that can be delivered, (or which can be used for reference purposes in settlement) and a standard timing of such settlement. A futures contract may be offset prior to maturity by entering into an equal and opposite transaction. The standardized items in a futures contract are:

  • Quantity of the underlying
  • Quality of the underlying
  • The date and the month of delivery
  • The units of price quotation and minimum price change
  • Location of settlement

Features of Future Contracts

1. Future contracts are standardised where conditions relating to date, quantity and delivery are fixed. It cannot be negotiated between buyer and seller.

2. Future contracts are regulated by SEBI.

3. Prices of various future contracts are available in stock exchanges.

4. Future contracts are more liquid because participants involved in future contracts are more.

5. Counter party risk in case of future contracts are less.

6. Initial margin is required in case of future contract.

7. Futures contracts are traded in stock exchange and it is transferable.

8. In futures the balance is settled everyday (also called mark to market settlement).

Forward Contracts Meaning

A forward contract is an agreement to buy or sell an asset on a specified date for a specified price. One of the parties to the contract assumes a long position and agrees to buy the underlying asset on a certain specified future date for a certain specified price. The other party assumes a short position and agrees to sell the asset on the same date for the same price. Other contract details like expiration date, price and quantity are negotiated bilaterally by the parties to the contract. On the expiration date, the contract has to be settled by delivery of the asset. The forward contracts are normally traded outside the exchanges.

Features of Forward Contracts

The salient features of forward contracts are as given below:

1. They are bilateral contracts and hence exposed to counter-party risk.

2. Each contract is custom designed, and hence is unique in terms of contract size, expiration date and the asset type and quality.

3. The contract price is generally not available in public domain.

4. On the expiration date, the contract has to be settled by delivery of the asset.

5. If the party wishes to reverse the contract, it has to compulsorily go to the same counter-party, which often results in high prices being charged.

Difference between future and forward contracts

At a basic level, futures are also forwards but in a more organized and regulated form that are executed through exchange. The exchange acts a guarantee to any counter-party risk. To summarize, the main differences between forwards and futures are:

Basis

Forward contracts

Future contracts

Trading

Forward contracts are traded over the counter.

Futures contracts are traded in stock exchange.

Regulation

Unlike futures, Forward contracts are self regulated.

Future contracts are regulated by SEBI.

Negotiation

Forward contracts can be negotiated between buyers and sellers.

Future contracts are standardised where conditions relating to date, quantity and delivery are fixed. It cannot be negotiated between buyer and seller.

Settlement

Forwards contracts are settled on  a maturity date.

In futures the balance is settled everyday (also called mark to market settlement).

Transferability

Forward contracts are contracts between two parties and hence not transferable to third parties.

Future contracts are tradable and transferable.

Initial margin

There is no need of initial margin in case of forward contracts.

Initial margin is required in case of future contract.

Counter party risk

Forwards are bilateral contract and hence counter party risk in case of forward contracts are very high.

Counter party risk in case of future contracts are less.

Liquidity

Forward contracts are less liquid and also there is a high chance of default by a party.

Future contracts are more liquid because participants involved in future contracts are more.

Contract price

Contract price of  a forward contract is not known to the public.

Prices of various future contracts are available in stock exchanges.

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