Understanding the difference between Future and Forward contracts
If you are involved in investing and trading, you must have come across the terms “future” and “forward” contracts. These two types of contracts are critical in the financial world, and understanding the differences between them is important for making informed investment decisions.
Definition of Future Contracts
Future contracts refer to an agreement between two parties to buy or sell a particular asset at a predetermined price and date in the future. These contracts are standardized and traded on an exchange. The underlying asset can be anything from commodities, currencies, stocks, and more.
One of the significant characteristics of a future contract is that it is legally binding, and both parties must fulfill the contract’s terms. The contract’s terms include the amount of the underlying asset to be bought or sold, the price at which the transaction will take place, and the date of delivery or settlement.
Definition of Forward Contracts
Forward contracts, on the other hand, are similar to future contracts, as they involve an agreement between two parties to buy or sell an asset at a set price and time in the future. However, forward contracts are not standardized, and they are privately negotiated between the parties involved.
One of the significant characteristics of forward contracts is that they are customized to fit the specific needs of the parties involved. As such, the terms of the contract can vary widely depending on the nature of the transaction.
Another key difference between forwards and futures is that forwards are not traded on exchanges. As such, they are less liquid than futures contracts.
Differences between Future and Forward Contracts
The main differences between future and forward contracts are summarized below:
1. Standardization: Futures contracts are standardized and traded on exchanges, while forward contracts are customizable and traded privately.
2. Legal binding: Futures contracts are legally binding, with both parties required to fulfill the contract’s terms. Forward contracts are also legally binding, but they are enforceable through private negotiations.
3. Settlement: Futures contracts settlement is done daily, while forward contracts settlement is done at the expiration or delivery date.
4. Liquidity: Futures contracts are more liquid than forward contracts, mainly because they are traded on exchanges.
Conclusion
In conclusion, while future contracts and forward contracts are similar in concept, there are crucial differences between them that can significantly impact investment decisions. Future contracts are standardized, legally binding, and traded on exchanges, while forward contracts are customizable, legally binding, and traded privately. Knowing the differences between these contracts can help investors evaluate which type of contract is best suited for a particular investment strategy.
Table difference between future and forward
| Future | Forward |
|---|---|
| It is a standardized contract to buy or sell an underlying asset at a future date. | It is a private contract between two parties to buy or sell an underlying asset at a future date. |
| It is traded on an exchange and is regulated by a specific exchange. | It is not traded on an exchange and is not regulated by any exchange. |
| The contract size is standardized by the exchange. | The contract size is customized according to the needs of the parties involved. |
| It requires the parties involved to maintain margins, which are adjusted daily. | It requires the parties involved to post an initial margin, but the margin is not adjusted daily. |
| It is settled on the expiration date. | It can be settled on any date agreed upon by the parties. |
| It is mostly used by investors who want to hedge or speculate on price movements. | It is mostly used by companies who want to hedge against foreign exchange or commodity price risk. |