Difference between forward and future contract
Understanding Forward and Future contracts can greatly benefit individuals interested in the world of derivatives and financial markets, as it provides them with valuable insights and knowledge to navigate these realms effectively. While both Contracts serve as tools for managing risk and speculating on future price movements, they differ in various aspects.
This comprehensive comparison between Forward and Future Contracts sheds light on their distinctive features, including structure, trading mechanism, and customisation. By grasping the nuances of these Contracts, investors can make informed decisions about which instrument best suits their needs. Read on as we explore the differences between Forward and Future Contracts, providing you with a solid foundation to navigate the dynamic landscape of Derivative trading.
Definition of Forward Contract
A Forward Contract is an agreement between two parties to buy or sell an asset at a certain price at a predetermined time in future. It has flexible terms regarding the number of units, nature and time of delivery, etc. For instance, if you want to sell a unit at its current price of ₹ 2000, but you feel its price might fall soon. So, you sign a forward contract with the buyer. According to the agreement, you will sell the unit at the current price after six months. If its price falls by then, you will not incur any loss. However, if its price increases, you will only get the price mentioned in the agreement.
Definition of Futures Contract
A Futures Contract is a legal binding to buy or sell an underlying component at a certain price at a specified date on the futures exchange. It includes a clearance house between both parties to monitor the transaction and minimise the default risk. For instance, if you agree to trade an asset at a fixed price on a future date, you must deliver the asset on the agreed date, irrespective of its cost at that time. In the context of forward and future contracts, "delivery" refers to the obligation of the party who sold the contract to provide the underlying asset to the buyer on the agreed-upon future date. It means physically transferring or settling the asset as per the terms of the contract, regardless of its current market price.
Key Differences Between Forward and Futures Contracts
Forward and Future Contracts share a common fundamental function in the financial world as tools for managing risk and speculating on future price movements. However, there are differences between them. Check out the difference between Forward and Future Contracts.
| Basis | Futures Contract | Forward Contract |
|---|---|---|
| Customisation | A Futures Contract is standard in terms of quantity, delivery, and date of the asset. | The buyer and seller negotiate the terms of a Forward Contract. Hence it is highly customisable as per the parties’ mutual consent. |
| Markets Involved | Involves an organised securities exchange for trade | A Forward Contract is traded OTC (Over the Counter). So, it does not include any secondary market |
| Settlement Date | These contracts involve daily mark-to-market settlements, where gains or losses are settled daily based on market fluctuations. | Has a maturity date for settlement. |
| Counterparty Risk | A Futures Contract has a lower risk involved. | A Forward Contract has a high counterparty risk. |
| Default Risk | A Futures Contract involves clearing houses that guarantee the transaction with constant monitoring. So, it has almost no risk of default. | A Forward Contract has a high chance of party default since the agreement is a private one. |
| Contract Size | Has a fixed size. | Depends on the contract terms. |
| Contract Maturity | Pre-determined in a Futures Contract. | According to the contractual terms. |
| Collateral Requirement | A Futures Contract requires an initial margin as collateral. The initial margin is the initial collateral amount required for entering a position. | Does not involve any collateral. |
| Regulation | Securities exchange regulates a Futures Contract. | It is Self-regulated. |
| Transaction Method | Traded over the stock exchange. | Negotiated between parties without involving any intermediary. |
| Price Discovery Mechanism | Transparent price discovery mechanism. | Opaque pricing structure according to the parties’ consent. |
| Liquidity | High | Low |
| Guarantee of Returns | The value of the derivative contract is determined solely by market rates, and due to low counterparty risk, it is settled daily. | Since the counterparty risk is significantly high, it has no guarantee or returns. You must wait until the maturity period. |
| Market Supervision | Governing body is a government-controlled marketplace, like a clearing house | No controlled supervision |
| Pre-Termination | Can be cancelled before the expiry date. | Opposite transactions in derivatives can involve distinct or similar counterparties, depending on the specific trade and arrangement. |
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The platform offers educational resources, research tools, and market analysis to empower investors in making informed decisions regarding Forward and Future contracts. Whether you are interested in hedging against price fluctuations or speculating on future market movements, Axis Direct equips you with the necessary knowledge and tools to navigate the complexities of these Derivative instruments effectively.
With our commitment to transparency, customer support, and seamless trading experiences, you can carry out hassle-free trades, maximising the potential of Forward and Future Contracts in your investment portfolio.
Conclusion
A comprehensive comparison of Forward and Future Contracts reveals their shared fundamental function in managing risk and speculating on future price movements. While they may have similarities, their distinctions in structure, trading mechanism, and standardisation are important factors to consider when engaging in Derivative trading. By understanding these key differences between Forward and Future Contracts, investors can make informed decisions and leverage the unique advantages offered by each contract type.
Disclaimer: Investments in derivatives and other financial instruments carry risks. Past performance is not indicative of future results. Consult a financial advisor and carefully assess your risk tolerance before making any investment decisions.