Futures and forwards are contractual agreements to buy or sell financial assets or commodities at a predetermined future date and price. They serve essential functions in financial markets related to risk management, speculation, and price discovery.

However, there are several key differences between forward and future market contract with examples, including contract specifications, regulations, counterparty risks, and more. This comprehensive guide will clarify difference between forward contract and future contract while providing practical insights into using futures and forwards effectively in trading and hedging strategies.

What are Futures Contracts?

Futures contracts are legal agreements to buy or sell a commodity or financial instrument at a predetermined price at a specified time in the future. They are standardised contracts that trade on regulated futures exchanges, facilitating an efficient market. The main purpose of futures contracts is to hedge against price risk or speculate on future price movements.

For example, a farmer might wish to lock in a future selling price for their crop to protect against falling prices at harvest time. They can sell a futures contract that obligates them to sell the crop to the buyer at the agreed price when the contract expires. The buyer of the contract is obligated to purchase the crop at that price at expiration. 

Neither party has to hold the actual commodity – they can offset their obligation by buying/selling an opposite contract before expiration if they wish. Futures allow producers and consumers to lock in prices today for transactions that will take place in the future, helping them manage price risk.

Features of Future Contracts

Here are some of the features of Future contracts:

• Standardisation

Futures contracts are highly standardised. Exchanges predetermine essential terms of the contracts, such as the asset type, the quantity of the underlying asset, contract size, expiration date, etc. For example, one gold futures contract on MCX would have a standard quantity of 100 grams. 

This standardisation forces uniformity into all futures contracts for a particular asset, enabling efficient large-scale trading without needing to negotiate the specific details of each individual contract. Traders thus know exactly what they are getting. The predictable and simplified structure also facilitates a very liquid and efficient marketplace.

• Transparency

Another hallmark of futures contracts is transparency. The prices of futures contracts are clearly visible to all participants in public markets and trading platforms, reflecting underlying supply and demand in real-time. 

This level of transparency ensures that traders can make informed and up-to-date trading decisions based on the available data, promoting fair and competitive trading. It also makes futures contracts much less risky compared to over-the-counter products with opaque pricing.

• Liquidity

Futures contracts tend to be very liquid due to centralised trading on regulated specialised derivatives exchanges. High transaction volumes mean traders can easily enter or exit positions in most futures contracts without significantly impacting prices. 

There is generally ample liquidity to support both short-term speculation and long-term hedging strategies. The liquidity lowers trading costs and allows flexibility in taking positions.

• Margin Requirements

While trading futures contracts does not require paying the full value upfront, there are margin requirements. Traders have to maintain a minimum margin account balance set by the exchange to cover potential losses from adverse price movements. This margin acts as collateral security against defaults and prevents buildup of excessive leverage in the system. 

However, it also enables traders to take much larger positions than investing directly in the underlying asset. The margin requirements strike a balance between risk management and enabling traders to amplify profits or losses through leverage.

What are Forward Contracts?

A forward contract is a customised, non-standardised agreement between two parties to buy or sell an asset at a specified price on a future date. Unlike futures contracts, forward contracts are privately negotiated and are not traded on an exchange.

For example, an airline company might wish to lock in future fuel prices to protect against rising costs. They can enter a forward contract with a fuel supplier to purchase a fixed quantity of jet fuel at an agreed price in six months. This guarantees the airline will pay that price, even if the market price for fuel rises higher. The fuel supplier takes on some risk but can also lock in guaranteed future revenue.

Forwards allow companies to hedge against unfavorable price movements in commodities or currencies they know they will need in the future. They offer more flexibility than standardised futures – the delivery date, amount, and terms can all be customised as per the parties’ needs. However, the lack of a central clearing house also gives them more counterparty risk than futures contracts.

Features of Forward Contracts

Below are the key features of forward contracts:

• Customisation

Forward contracts are highly customisable to meet the specific needs of the transacting parties. The asset type, quantity, price, settlement date, and other critical terms are negotiated privately between the buyer and seller. This flexibility to customise the settlement process, underlying asset etc. allows the contract to suit each party’s individual requirements in a way standardised exchange-traded derivatives cannot. 

For instance, a commodity producer and a manufacturer might negotiate a tailored forward contract for materials without a futures market.

• Flexibility

In addition to customisation, forward contracts offer the flexibility to transact in a wider range of commodities, currencies, or other assets that lack liquid futures contracts or standardised terms. The parties have complete freedom to specify the terms to align with their goals, capabilities, timeframes, etc. This flexibility makes forward contracts suitable for specialised situations.

• Counterparty Risk

Unlike futures contracts, which are guaranteed against default by the exchange, forwards carry direct counterparty risk. Each party bears the risk that the opposing party may fail to meet their contractual obligations at settlement. There is no centralised clearing house to vet creditworthiness or ensure adequate collateral is posted. Parties must directly evaluate each other’s ability to perform the contract.

• Settlement Procedures

Forward contracts have flexible settlement procedures agreed upon during initiation. Settlement may involve physical delivery of the actual underlying asset or cash settlement, depending on both parties’ preferences and capabilities. For instance, a commodity producer lacking storage space may prefer cash settlement of the contract. This flexibility caters to each party’s needs.

What is the Difference Between Forward Contracts and Future Contracts?

Here are the difference between forward market and future market:

Conclusion

As key pillars of derivatives markets essential for risk management and speculation, futures and forwards retain relevance for diverse stakeholders ranging from farmers to central bankers. 

As adoption accelerates globally across asset classes, from equities and currencies to newer alternatives like carbon credits, participants benefit by better understanding the comparative advantages of these two derivatives instruments and deploying them effectively toward their strategic investment and hedging goals.