The financial contracts, Forwards and Futures are quite similar in nature and follow the same fundamental function; they allow traders to buy or sell the specific type of asset at a given price at a given time. However, there exist some important differences between the two. The major difference between Futures and Forwards is that Futures are traded publicly on exchanges and the Forwards are privately traded.
The Futures Contract
The Futures contracts, also referred to as Futures, are those standardized instruments that are traded through brokerage firms, on the stock exchange which trades that specific contract. The terms for the Futures contract like the volume, delivery dates, credit procedures and technical specifications are standardized for each kind of contract. Similar to the ordinary stock trading, both the parties involved will work through their brokers and transact in the futures trade.
Currency Futures are one of the most traded futures contracts. It is also known as FX Future and is a Futures contract using which the trader can exchange one currency with another on a said date in the future at the price, which is fixed on the day of purchase.
The Forward Contract
The Forward Contract or the Forwards is the agreement which takes place between two parties to either buy or sell the asset at the pre agreed time at a specific price. The Forward contract can entail both the credit risk and the market risk and the profit or loss on such contracts is only known during the time of settlement.
Like in Futures, Currency Forwards is one binding contract in the foreign exchange market which locks the exchange rate for a future date for the sale or buy of a currency. This is normally implemented like hedging and does not involve any initial payment. The Currency Risk too is comparatively low in forwards than the currency futures.
How is Futures Contract different from Forward Contract?
The Structure and Purpose
The Forward contracts can be customized as per the needs of the customer. There is no initial payment required and this is mostly used for the process of hedging. The Futures contracts on the other hand are standardized and traders need to pay a margin payment initially.
The Method of Transaction
The Forward contracts are negotiated directly by the seller and the buyer and are not regulated by the markets. The Futures Contracts are quoted and traded over the stock exchange and are government regulated.
The Risk and Guarantees
The Forward contracts include a high counter party risk and there is also no guarantee of asset settlement till the maturity date. The Futures contract involves a low counterparty risk and the value is based on the market rates and is settled daily with profit and loss.
The Contract Size and Maturity
The Forward contracts mature after the delivery of the commodity and this may not happen in Future contracts. The size of the contract is standardized in Futures and it entirely depends upon the requirements of both the parties in Forwards.
The Risk Factor
When an agreement happens between two different parties, there can be a risk that any one party can renege on the agreement terms. Any of the party can be unwilling or be unable to follow the terms during the time of settlement. This risk is termed as the counterparty risk.
In Futures, the clearing house of the stock exchange acts as counterparty for both parties. This reduces the credit risk and the risk is redued further as all the positions taken in futures are marked to market every day. With such features, there is absolutely no counterparty risk when it comes to a trade in futures.
On the other hand, the Forward contracts do not have any such mechanisms. The Forwards are always settled during the time of delivery and thus the profit or a loss can only be known during settlement. Hence, the loss can be more for the participants in Forwards which can be due to a default.
To conclude, be it Futures or Forwards, any trader needs to have a reliable broking firm that can provide a streamlined access to both Futures and Forwards at reasonable rates. Click here to open a trading account at Motilal Oswal now!