In the stock market, trading in derivatives, like forwards and futures contracts, is quite popular. However, there’s confusion between forward and future contracts, because they initially seem to be similar. They’re not. Both are financial contracts based on future asset prices, but they operate differently. In this blog, we will break down these differences, helping you grasp how each contract type fits into the trading puzzle.
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What is a forward contract?
A forward contract is an arrangement in finance between two parties for the purchase or sale of an asset at a specific future date and price. It’s a common tool in various markets, like commodities and currencies, to manage the uncertainty of future prices.
For example, consider Raju, a farmer. He worries that grain prices might fall, so he enters a forward contract with a buyer to sell his grain at today’s price in three months. If the price falls, Raju avoids loss, but if it rises, he misses out on potential profit.
These agreements stand out for their adaptability, allowing customisation in quantity, delivery time, and asset type. However, there are risks associated with this flexibility, such as credit and market risks.
Even though they provide a hedge against price volatility, forward contracts carry certain potential risks, so it’s critical to consider the advantages and disadvantages of forward contracts carefully. They serve as a strategic means to stabilise financial plans in a fluctuating market environment.
What is a future contract?
A futures contract is a standardised agreement traded on an exchange wherein parties commit to purchasing or selling an item at a fixed price at a future date. The advantages and disadvantages of futures contracts are unique in comparison to forward contracts.
Firstly, futures are traded on standardised exchanges, which means they follow set rules and regulations. This increases their transparency and opens them up to a larger group of individuals. Secondly, the value of a futures contract is settled daily, not just when the contract matures. In other words, futures can be bought and sold at any point up to the contract’s expiration.
For instance, in a futures contract involving the Indian Rupee and the US Dollar, you agree to exchange these currencies on a set future date at a price decided today. Futures contracts are commonly used in commodities and stock markets, in addition to currencies. Their structured format and exchange-based trading make them a reliable tool for managing financial risks.
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Forward contract vs future contract
Both forward and futures contracts have a lot in common. Primarily, they are financial derivatives used for buying or selling assets at a future date. They play a crucial role in hedging against price fluctuations and are based on predictive techniques to lock in prices. Additionally, they mandate the execution of transactions by a specific date.
Now, let’s look at the key differences:
- Trading platform: Futures contracts are dealt on standardised exchanges, making them more accessible and regulated. On the other hand, forward contracts are dealt over-the-counter (OTC), involving direct negotiations between two parties.
- Settlement: Futures are settled daily, with profits or losses calculated each day. Forward contracts, however, are settled only at maturity, which can lead to a larger cumulative gain or loss.
- Regulation: Futures are regulated by market bodies like the Stock Exchange Board of India (SEBI), ensuring certain standards and protections. Forward contracts rely on the conditions set forth by the parties and are self-regulatory.
- Standardisation: Futures contracts include predefined terms and conditions, including size and delivery dates. Forward contracts, which are customised to meet the demands of the both parties, lack this uniformity.
- Risk of counterparty default: Forward contracts are more likely to have defaults by one side. In this sense, there is less risk associated with futures because the exchange serves as the counterparty, guaranteeing contract execution.
- Initial margin: An initial margin requirement is a protective measure against possible losses in futures contracts. Typically, there is no need for an initial margin on forward contracts.
- Liquidity: Futures are typically more liquid due to their standardisation and exchange trading. Forward contracts can be less liquid, given their custom nature and the fact they are OTC.
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Bottomline
Understanding the difference between futures and forwards is crucial for anyone involved in stock market trading. Both instruments are useful for protecting against price swings, although they are very different from one another.
Futures are standardised and regulated, offering security but less customisation. Forwards, conversely, are flexible and tailored to the parties involved but carry higher counterparty risk. Ultimately, choosing between forwards and futures should align with your investment goals and risk appetite, forming a strategic part of your overall trading approach.
FAQs
Forwards are private, customisable deals made directly between parties, settled at maturity. Whereas futures are standardised contracts traded on exchanges, settled daily, with regulated oversight reducing the risk of non-fulfilment.
Forward and future contracts are agreements to trade an asset at a future date and price. Forwards are private, OTC, and customisable, while futures are standardised and traded on exchanges. Swaps involve exchanging cash flows or financial instruments, often used for risk management in interest rates or currencies.
A forward contract is an agreement to buy or sell an asset at a future date for a specific price. Consider a wheat farmer agreeing to sell a certain amount of wheat to a buyer at a fixed price to be delivered in six months. This helps the farmer guard against potential price drops.
A forward contract might be preferred for its customizability and private negotiation between parties, allowing for specific terms tailored to their needs. However, it’s not necessarily better than a future contract, as futures offer standardisation, higher liquidity, and reduced counterparty risk through exchange trading and regulation.
Three major differences between forward and futures contracts are: 1) Forward contracts are traded over-the-counter and customisable, whereas futures are standardised and traded on exchanges. 2) Futures require daily settlement, while forwards settle at contract maturity. 3) Futures are regulated with reduced counterparty risk; forwards are self-regulated with higher risk.