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How futures are a great improvement over forward contracts?

A future and a forward are essentially the same. Basically they are contracts to buy or sell a contract at a future date at a fixed price. For example, a farmer and  a flour factory can enter into an agreement wherein the farmer will supply a certain fixed quantity of wheat to the factory at a price and date that is fixed in advance. On the agreed date, the farmer is obliged to supply the quantity of wheat at that price and has the right to demand that the flour factory take delivery on those terms. At the same time, the flour factory is obliged to take delivery of the quantity of wheat at the agreed price and can also demand that the farmer supply the quantity at the said price on that date. Both the farmer and the flour factory have a right and an obligation at a particular date and price. This is the most basic form of a future contract. The most common form of forward contract in India is the dollar forward contract that is used to hedge currency risk.

Structurally, the futures contract is the same. Then what is the difference between forward and future contract, with example? Most of us are familiar with futures contract because that is what we normally buy and sell in the stock markets. Individual traders can buy futures on stocks, indices, commodities, currencies etc. A future is a right and an obligation for delivery of an asset at a future date at an agreed price. Let us look at the advantages of futures contracts along with a forward contract vs future contract comparison. There are 3 basic areas of difference that you need to understand between a forward and a future.

1.  Futures are exchange traded; forwards are not

This is one of the fundamental differences between futures and forwards. Forwards are popularly known as over-the-counter (OTC) contracts. OTC contracts are typically executed over the telephone. For example, if a large importer wants to hedge dollar risk then they will approach the bank. The bank will, in turn, talk to another bank and get a forward deal signed up. These are private deals between two large banks and not traded. However, since the parties are mega banks it is still quite a safe proposition. Futures are traded on the exchange and therefore they are more liquid. In a stock exchange there are large number of buyers and sellers and the price discovery also happens through a very transparent market mechanism. For example if you take the case of Nifty Futures, there are thousands of buyers and sellers at any point of time and hence liquidity is hardly an issue. Today, exchanges have tried to bring futures trading in as many asset classes as possible.

2.  Futures are standardized and hence liquidity creation become a lot easier

One of the big advantages of futures is that they are standardized. How are they standardized? For example, if you take the Nifty futures on the NSE, there are a quite a few things that are standardized. Firstly, all index futures are cash settled only. Secondly, the lot sizes of Nifty futures are standardized at 75 units and any trader can place buy or sell orders only in minimum size of 1 lots. Thirdly the methodology for calculation of VAR margins and ELM margins are also standardized. Fourthly, the expiries are standardized. You can either have a 1 month, 2 month or 3 month contracts only. Lastly, they are also standardized in terms of the underlying. The underlying has to either be an index or a specific stock. When contracts are standardized, they automatically become liquid. In the case of forwards, the liquidity is a major challenge. For example, if you get into a forward contract and want to exit midway then the only hope is that someone with a similar requirement also turns up. Otherwise, you are stuck in the contract till the maturity.

3.  Futures are relatively safer and more secure compared to forwards

 There is a subtle difference that you need to understand. The most popular forward contract in India is the dollar forward. The players in this market are typically the large banks and financial institutions and hence the risk of parties going back on these contracts is ruled out. But there are many forward contracts that are outside the banking channel. Here the risk is real. If one party defaults on its commitment, the other party only has a legal recourse under the Indian Contracts Act and the resolution can take a long time. This problem is resolved in futures through the clearing corporation mechanism. When you trade in the futures market, every trade carries counter guarantee by the clearing corporation of the exchange. For example, when X buys 5 lots of Nifty futures and Y sells 5 lots of Nifty futures, then both of them are actually placing the trade through the NSE Clearing Corporation (NSCCL). The NSCCL actually is the counterparty to both the trades. If one of the party defaults then the NSCCL will honour the trade and then initiate recovery from the other party. That is why we don’t see payment crisis or payment defaults in the stock exchange these days.

Forwards have a role to play in closed markets but the world is increasingly moving towards the more transparent mechanism of futures trading.

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