When it comes to risk management in the financial markets, Future and Forward contracts help traders and investors hedge their risks and even profit from price trends and market conditions.
While both futures and forwards serve the same purpose, they distinctively differ from each other on several counts.
What’s the difference between Forward and Future contracts?
Futures and forwards are derivative contracts that derive their value from the value of an underlying asset. The level of customisation, regulations, counterparty risks and settlement mechanism among others are some of the most differentiating factors between futures and options.
Futures vs. Forwards
| Parameter | Forwards | Futures |
|---|---|---|
| Definition | A Forwards contract is a private agreement between two parties to buy/sell the underlying asset at a predetermined date and price. | A Futures contract is a standard contract traded on recognised exchanges and has specified terms and conditions common to all |
| Level of customization | High: A Forwards contract can be customised to address the specific requirements of parties involved in a contract. | Low: Futures rely on uniformity. |
| Expiry and settlement | Contracts are usually settled on the day of expiry by the delivery of an underlying asset or cash. | Can be settled even before the expiry of a contract. Mostly cash settled, but that’s not mandatory. |
| Counterparty risk | High, since Forwards are Over-the-Counter (OTC) contracts, concerned parties are exposed to counterparty risks. | Low. The clearing houses guarantee trades and settlements. |
| Margin requirements | Unless otherwise stated in an OTC contract, forwards don’t require any margin | Margin requirements are standard and well-defined for futures. |
Highlights: Futures vs. Forwards
Summary
Forwards are instruments that tend to be used by people with specific needs such as taking positions at odd lot sizes, or irregular expiry tenures, given their high customizability, while Futures Contracts are standardised and do not allow contract flexibility. Depending on your requirements, risk appetite and loss-absorption capacity, you might choose between future and forward contracts. If you are a stock market trader/investor, Futures contracts might suit you more than Forwards. On the other hand, if you are a businessman and your business exposes you to the price volatility of a specific commodity, Forwards contracts might offer you more flexibility to hedge your risks.
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