Difference between Futures and Forward Contract | Easily Explained

Difference between Futures and Forward Contract

The futures and forward contract are types of derivative instruments, mean their value is derived from underlying assets. Although both futures and forward contract is similar in most context, yet there are many differences if we study these contracts conceptually.

In this article, we will focus on the difference between futures and forward contract in brief.

Futures and Forward Contract:

Let us first understand the meaning and definition of futures and forward contract then we’ll distinguish between these terms later in this lesson.

‘The forward contract can be defined as an agreement between two parties (Buyer & Seller) to trade (buy or sell) the financial assets over the counter on a future specified date at a mutually agreed price which is determined at the time of formation of such agreement.”

In simple words, it is a contract between two persons which obligate both the persons to buy and sell financial assets in future at a fixed and mutually agreed price.

The forward contracts are customisable according to the terms and requirements of both the parties/ persons and typically done between the persons who are known to each other. There doesn’t exist any intermediary/ middlemen which take care of the execution of the contract.

On the other hand, “A futures contract refers to the standardised financial derivative contract between two parties obligate to buy or sell the underlying assets on a future specified date at a predetermined price.”

The futures contract is regulated and traded under the supervision of the stock exchanges. Typically, in futures contracts two persons, unknown to each other, trade and speculate over the underlying assets.

The underlying assets could be equity shares, commodities, precious metals, currencies or indices, date of expiry and price of assets shall be determined at the time of the creation of a contract.

Futures vs Forward Contract (Comparison Table):

BASIS OF COMPARISONFUTURESFORWARD CONTRACT
MeaningIt is a financial contract but in standardised terms and conditions between two parties to buy and sell specific lots of underlying assets in future date at a predetermined price.It is an agreement between two parties to buy and sell the underlying financial assets/ securities on a future date.
IntermediaryStock Exchange No Intermediary
Traded OnStock ExchangeOver the counter (OTC)
MarginsRequiredNot Required
Counterparty RiskNOHigh
SettlementDaily BasisAt Expiry of Contract
Expiry of ContractFixedCustomizable
Terms & ConditionsMoreLess

Difference between Futures and Forward Contract:

The futures and forward contracts can be distinguished based on the following aspects.

1) Meaning:

As we learned above, a forward contract is an agreement between two parties to buy and sell financial assets/ securities on a future date, however, a futures contract is also a financial contract but in standardised terms and conditions between two parties to buy and sell specific lots of underlying assets in future date at a predetermined price.

2) Intermediary:

The futures contract are regulated and traded by the stock exchanges, on the other hand, forward contracts are traded over the counter (OTC), means there is no intermediary involved to ensure the performance of the contract.

3) Traded On:

The futures contracts are traded in the stock exchanges, on the other hand, forward contracts can be traded over the counter (OTC) only.

4) Margins:

In futures contracts, there always require to deposit some margin money to enter such contracts whereas the margin money is not compulsory in case of the forward contracts.

5) Counterparty Risks:

The counterparty risk in the forward contracts is more as there is no intermediary, on the other hand, the futures are absolutely secured and the counterparty risk is almost negligible as the performance of contracts is guaranteed by the stock exchange itself.

6) Settlement:

The settlement of funds is done on expiry date in the forward contracts, however, in case of futures contract settlement is done on a daily basis.

7) Expiry of Contract:

The expiry date of the forward contracts is determined as per the mutual understanding of both parties whereas the date of expiry is fixed and can’t be customised in any circumstances.

8) Terms & Conditions:

The rules and regulations are strict in the futures contract, however, in case of the forward contracts the terms and conditions are liberal.

Conclusion:

Hope this article would have helped you to understand the difference between futures and forward contract. In a nutshell, a forward contract is tailor-made contracts which are created to fulfil the interest of both the parties involved, however, a future contract is having standard terms and conditions made by the stock exchange to ensure the guaranteed performance of the contracts on the expiry date.

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Difference between Futures and Options

Difference between Primary and Secondary Markets

Difference between Money Market and Capital Market

Difference between Equity Shares and Preference Shares

 

References: Investopedia forward vs futures contract (source)

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