Learn about the key differences between forward and future contract
Whether you have been trading in the stock market for numerous years or you are a novice trader, you must know what derivatives trading is. Just to recall, derivatives trading involves buying and selling derivatives contracts (instruments that derive their value from an underlying asset) in the stock market. However, before you invest your hard-earned money in derivatives trading, you must have in-depth knowledge about it. One thing that confuses most traders is that Forwards and Futures contracts are the same. This is not true.
Forwards and Futures are financial contracts that are quite similar and follow the same fundamental function; however, there exist a few differences between them. Read the article to learn more about the differences between these two types of derivative contracts.
What are Forward Contracts?
Also known as Forwards, it is an agreement between two parties to purchase/sell the underlying asset at a specific price at a predetermined time. In this type of contract, you can only know the profit and loss accrued at the settlement date.
You can trade a Forward Contract in different over-the-counter derivatives such as stocks, commodities, currencies, and more. These contracts can be traded over the counter and not on the exchange.
What are Futures Contracts?
Also known as Futures, it is a standardized financial contract in which a quantity and price are predetermined, and the price is payable at a future date. These contracts can be traded in various segments, such as stock, currencies, and commodities through stock exchanges. You must know that the parties involved are legally bound to execute the contract. Following are the standardized terms and conditions included in the Futures Contract.
- Delivery Date
- Trade Volume
- Credit Procedure
- Other Technical Specifications, if required
Let’s understand this with an example – Consider currency as an underlying asset. Now, using a currency futures contract, you can exchange one currency with another on a specific date at a predetermined rate (fixed on the date of purchase).
Similarities between Forward Contract and Futures Contract
Before we move on to the differences between these contracts, let’s understand the similarities.
- Both are financial derivatives instruments
- Both are agreements to buy/sell derivatives in the future
- Both help mitigate risk and losses due to price fluctuations
- Both contracts use predictive techniques to ensure the price is locked in
- Both require buyers and sellers to execute a transaction by a specific date
Differences between Forwards Contract and Futures Contract
Refer to the below table to understand the significant differences between the Forward and Futures Contract.
|Basis of Differentiation||Future Contract||Forward Contract|
|Settlement Type||Daily (by the stock exchange)||On the maturity date (as agreed by the parties)|
|Regulatory Body||Market regulators like SEBI||Self-regulated as they aren’t traded over-the-counter|
|Collateral||Margin required as per the stock exchange rules||No requirement of initial margin|
|Maturity Date||On a predetermined date||As per the contract terms|
Apart from the above key differences, below are some of the other differences between the Forward and Future Contract.
1. On the basis of structure and scope
A Futures Contract is subject to standardization and as a trader you need to pay a margin payment initially. However, a Futures Contract can be customized per the trader’s needs, and no initial payment is required.
2. On the basis of the transaction method
A Futures Contract is traded over the stock exchange and is regulated by the government. On the other hand, a Forward Contract is directly negotiated between the two parties without any involvement of any government-approved intermediary.
3. On the basis of the price discovery mechanism
As a Futures Contract is standardized, it offers an efficient price discovery mechanism as compared to a Forwards Contract. Thus, the prices of a Futures Contract are transparent, while, a Forwards Contract has opaque pricing as two parties dictate it.
4. On the basis of the risks involved
Whenever two parties enter into an agreement, there is always a risk that any party is unwilling to follow the terms at the time of settlement. This risk is comparatively less in a Futures Contract as the stock exchange clearing house acts as a counterparty for both parties. However, a Forwards Contract is settled at the time of delivery, and profit/loss can only be ascertained at this time.
Now, you must have known that even though a Forward Contract and a Futures Contract might look similar, they are actually different. A Forwards Contract is an agreement between two parties to purchase/sell the underlying asset at a predetermined price on a specific date, while a Futures Contract is standardized, and the price is payable at a future date. After knowing the points mentioned earlier about differentiation, you can start your trading journey with clarity and confidence.