difference between forward and future contract

Forward Contract Vs. Futures Contract: Understanding the Difference

When it comes to financial trading, understanding the differences between various financial instruments is crucial if you want to make informed decisions. One question that often comes up is the difference between forward and futures contracts. In this article, we’ll explore the key differences between these two financial instruments.

What is a Forward Contract?

A forward contract is an agreement between two parties to buy or sell an underlying asset at a predetermined price and at a specified future date. The contract is customized to meet the specific needs of the two parties involved, and the terms of the contract are not standardized. This means that the buyer and seller of a forward contract can customize the contract to suit their specific needs. For example, they can negotiate the price, the quantity, and the date of settlement.

What is a Futures Contract?

A futures contract is a standardized agreement to buy or sell an underlying asset at a predetermined price and at a specified future date. The contract is traded on an exchange, and each contract is standardized in terms of size, settlement date, and price. This means that the buyer and seller of a futures contract have no control over the terms of the contract. The only thing they can do is to buy or sell the futures contract on the exchange.

The Main Differences Between Forward and Futures Contracts

The main differences between forward and futures contracts include:

Standardization

The most significant difference between forward and futures contracts is that futures contracts are standardized, while forward contracts are not. This means that futures contracts can be traded on an exchange, while forward contracts are usually traded over the counter.

Liquidity

Since futures contracts are traded on an exchange, they are more liquid than forward contracts. This means that it’s easier to buy and sell futures contracts, and the bid-ask spread is usually smaller than for forward contracts.

Counterparty risk

Another key difference between forward and futures contracts is counterparty risk. In a forward contract, there is a high level of counterparty risk, as the contract is between two parties, and there is no central clearinghouse to guarantee the performance of the contract. In contrast, futures contracts are guaranteed by a clearinghouse, which eliminates counterparty risk.

Flexibility

Forward contracts are more flexible than futures contracts, as they are customized to meet the specific needs of the two parties involved. This means that the parties can negotiate the terms of the contract, including the price, the quantity, and the date of settlement. On the other hand, futures contracts are standardized, and the parties have no control over the terms of the contract.

Conclusion

In conclusion, the main differences between forward and futures contracts are standardization, liquidity, counterparty risk, and flexibility. While forward contracts offer more flexibility, futures contracts are more liquid, less risky, and more standardized. Understanding the differences between these financial instruments is crucial if you want to make informed decisions in the financial markets.

Table difference between forward and future contract

	Forward Contract	Future Contract
Definition	A private agreement between two parties to buy or sell an asset at a predetermined price on a specified future date.	A standardized contract traded on an exchange to buy or sell an underlying asset at a predetermined price on a future date.
Customization	Contracts can be customized to meet the specific needs of the parties involved.	Contracts are standardized, with the same specifications for all market participants.
Counterparty Risk	Higher counterparty risk due to the lack of a centralized clearinghouse.	Lower counterparty risk as exchanges act as a centralized clearinghouse.
Liquidity	Generally less liquid due to being a private agreement between two parties.	Generally more liquid due to being traded on an exchange.
Delivery	Physically settled or cash settled, depending on the terms of the contract.	Cash settled, eliminating the need for physical delivery.
Market Access	Limited to parties who can agree on contract terms.	Accessible to anyone with a trading account on the exchange.