Forward Contract vs Futures Contract

A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time at a pre-agreed price. A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. So while the date and price are decided in advance in forward contract, a futures contract is more unpredictable. They also differ in the forms that a futures contract is standardized while a forward contract is made to the customer's need.

Standardization and exchange based trading of futures is the underlying reason for most of the differences between a forward and future transaction. Even though it may be intuitive that future trades are more constrained than forward trades and should hamper efficient markets, the standardization of the contracts stimulates futures market and enhances liquidity.

In contrast to forward contracts in which a bank or a brokerage is usually the counterparty to the contract, there is a buyer and seller on each side of a futures trade. The futures exchange selects the contract it will trade.

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Forward Contract

Futures Contract

Definition A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time at a specified price. A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price.
Structure & Purpose Customized to customer needs. Usually no initial payment required. Usually used for hedging. Standardized. Initial margin payment required. Usually used for speculation.
Transaction method Negotiated directly by the buyer and seller Quoted and traded on the Exchange
Market regulation Not regulated Government regulated market (the Commodity Futures Trading Commission or CFTC is the governing body)
Institutional guarantee The contracting parties Clearing House
Risk High counterparty risk Low counterparty risk
Guarantees No guarantee of settlement until the date of maturity only the forward price, based on the spot price of the underlying asset is paid Both parties must deposit an initial guarantee (margin). The value of the operation is marked to market rates with daily settlement of profits and losses.
Contract Maturity Forward contracts generally mature by delivering the commodity. Future contracts may not necessarily mature by delivery of commodity.
Expiry date Depending on the transaction Standardized
Method of pre-termination Opposite contract with same or different counterparty. Counterparty risk remains while terminating with different counterparty. Opposite contract on the exchange.
Contract size Depending on the transaction and the requirements of the contracting parties. Standardized
Market Primary & Secondary Primary

Contents: Forward Contract vs Futures Contract

edit Procedure

A futures contract gives the holder the obligation to buy or sell, which differs from an options contract, which gives the holder the right, but not the obligation.

Both parties of a "futures contract" must fulfill the contract on the settlement date. The seller delivers the commodity to the buyer, or, if it is a cash-settled future, then cash is transferred from the futures trader who sustained a loss to the one who made a profit. To exit the commitment prior to the settlement date, the holder of a futures position has to offset their position by either selling a long position or buying back a short position, effectively closing out the futures position and its contract obligations.

A position can also settled by a method called ‘exchange of physicals’ where a trader finds another trader with opposite position to his own and deliver the good, settling between them. This is the sole exception to the federal law that requires all trade place on the exchange.

In a forward contract, one party agrees (obligated) to sell, the other to buy, for a forward price agreed in advance. In a forward transaction, no actual cash changes hands(unlike margin payments for a future trade). No asset of any kind actually changes hands, until the maturity of the contract. The forward price of such a contract is commonly contrasted with the spot price, which is the price at which the asset changes hands (on the spot date, usually two business days). The difference between the spot and the forward price is the forward premium or forward discount.

edit Trade

While futures are traded on an exchange and are standardized, forwards always trade over the counter or they can be signed between two parties and are not rigid in their terms. Each forwards contract is user customized and made to order. Both Forward and Future trades are either delivered or cash settled. However, Future trades are easier to unwind as the market liquidity is high.

edit Transaction Methodology

Forwards transact only when purchased and on the settlement date. Futures, on the other hand, are rebalanced, or "marked to market". The marking to market involves each counterparty of a futures trade put a margin amount in an account with the clearing house which is daily adjusted for loss or profit.

edit Risk

While forward contracts are private agreements, there is always a chance that a party may default on its side of the agreement and risk is always involved. Futures contracts have clearing houses that guarantee the transactions, which drastically lowers the probability of default to almost never.

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