What are futures and forward contracts?. Both are contracts to deliver a commodity on a future date. But they are not the same. Here is all you need to know about futures and forward contracts.
Futures and forwards are contracts to deliver a commodity on a future date by a client. Their key differences include:
- Futures are always traded on an exchange, whereas forwards always trade over-the-counter, or can simply be a signed contract between two parties.
- Futures are highly standardized, whereas some forwards are unique. The price at which the contract is finally settled is different:
- Futures are settled at the settlement price fixed on the last trading date of the contract (i.e. at the end). Forwards are settled by the delivery of the commodity at the specified contract price.
- The credit risk of futures is much lower than that of forwards.
- Traders are not subject to credit risk because the clearinghouse always takes the other side of the trade. The day's profit or loss on a futures position is marked-to-market in the trader's account. If the mark to market results in a balance that is less than the margin requirement, then the trader is issued a margin call.
- The risk of a forward contract is that the supplier will be unable to deliver the grade and quantity of the commodity, or the buyer may be unable to pay for it on the delivery day.
- In case of physical delivery, the forward contract specifies to whom to make the delivery. The counterparty on a futures contract is chosen randomly by the exchange.
- In a forward there are no cash flows until delivery, whereas in futures there are margin requirements and a daily mark to market of the traders' accounts.
- Futures contracts ensure their liquidity by being highly standardized, usually by specifying: The underlying asset or instrument. This could be anything from a barrel of crude oil to a short term interest rate. The type of settlement, either cash settlement or physical settlement. The amount and units of the underlying asset per contract.
This can be the notional amount of bonds, a fixed number of barrels of oil, units of foreign currency, the notional amount of the deposit over which the short term interest rate is traded, etc.