Know the difference between a futures contract and a forward contract

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Forwards and Futures

Key Takeaways

  • Forward contract and future contract are both financial instruments related to the stock market.
  • Although both of them have quite a few similarities they are also very different in terms of investment.
  • Forwards contracts are mainly traded through OTC or over-the-counter derivatives
  • Futures contracts are administered by the government and that is why they have very less counterparty risk.
  • For forward contracts the counterparty risks are a bit higher because it is a private contract between two parties and no other authority or middleman is involved.
  • Details about futures contracts are publicly available and traders or investors can evaluate or examine them.

Summary in brief

  • What do we mean by Forward contracts?
  • What do we mean by Futures contracts?
  • In what aspects futures contracts and forward contracts are similar?
  • What are the primary differences between forward contracts and future contracts?
  • Is there an advantage to futures contracts over forward contracts?
  • Final words
  • Frequently Asked Questions

Derivative trading is an extremely common term in the stock market which is popular among both seasoned investors and novice traders. In derivative trading traders and investors mainly purchase and sell derivatives contracts. Derivative contracts are a type of stock market instrument whose inherent value has been obtained from a concealed asset.

Nevertheless, derivative trading is not everyone’s cup of tea because to invest in this type of stock market instrument you need to have precise and in-depth knowledge about the subject or else your precious money won’t be able to offer you any kind of revenue or return and you will be at the risk of losing all your funds. 

However, many people who regularly invest in the stock market think that derivative trading, futures contracts and forward contracts in the stock market are the same. It also involves a similar level of risk, which is entirely untrue.

If we are to compare forward and futures contracts then we will be able to find lots of similarities between them, nevertheless, you will also be able to find quite a number of differences among the same. Continue to read in order to gain a better understanding of forward contract vs future contracts as an investor and get benefited from the same while investing or trading in the stock market.

What do we mean by Forward contracts?

Forward contracts can be defined as a contract between two different parties who wants to buy or sell a specific financial asset at a given time period by paying or giving a pre-established price. Whenever you deal with this type of stock market instrument or contract you will only be able to know about the surplus or deficit you have accumulated on the predetermined date or time.

In case you are dealing with a forward contract you also need to remember that this type of instrument can be traded using multiple over-the-counter or OTC derivatives which include the likes of currencies, equities, commodities, etc. More importantly, as a trader, you won’t be able to trade forward contracts directly through the exchanges. Also, remember that both parties involved in a forward contract are required by law to fulfil the terms of the contract.

Now let us have a look at the conditions and guidelines that are part of the forward contract:

  • Credit procedure
  • Delivery date
  • Technical specifications
  • Trade volume

What do we mean by Futures contracts?

Futures contracts are considered to be a form of stock market instrument that can only be operated through stock market brokerage firms or exchanges platforms that specialize in this type of contract. For each and every kind of futures contract, the investors and traders have to follow standard terms and conditions including delivery dates, technical specifications, trade volume and the procedure for credit.

Similar to regular trading, in futures contracts both the parties who are involved in this contract complete their deal through their respective stock exchange platform. For your information, currency futures contracts are the most commonly traded futures contracts in the stock market.

We can go through a simple example in order to understand more clearly about futures contracts. For instance, you have selected the Rupee currency as part of your futures contract and made a particular deal on a specific date where you will exchange the Rupee currency for USD. When the predetermined date will arrive you will be legally bound to exchange the Rupee currency for USD at a fixed exchange rate mentioned in the contract.

Similar to futures contracts, currency forward contracts can be regarded as a single, legally enforceable agreement in the market for foreign currencies that fixes the exchange rate for the acquisition or sale of any particular currency at a future date. Furthermore, traders or investors won’t have to pay any upfront cost while investing in these contracts (which is very similar to hedging). In comparison to currency futures contracts, the currency risk in forward contracts is very minimal.

In what aspects futures contracts and forward contracts are similar?

As an investor or trader if you want to trade on forward contracts and futures contracts then first you will have to understand the similarities and differences between them. Before checking out the dissimilarities of forward and future contract let us check out their similitude:

  • On a specific date both the buyer and seller will execute their transactions using future contracts and forward contracts.
  • Both of these agreements can help investors and traders to cancel out the damage and inconsistency of prices on the stock market.
  • Future contracts and forward contracts are derivatives instruments directly related to the stock market.
  • In both agreements you need to predict the price using calculations in order to lock in the contracts.
  • Using both of these contracts you will be able to sell and purchase derivatives from the stock market.

What are the primary differences between forward contracts and future contracts?

Based on the method of the transaction

You don’t need to have any approved authoritative figure in order to initiate a forward contract with the other party. Only the buyer and seller are involved in this contract. Mostly, the futures contracts are modulated by the respective governments and investors can mainly invest or trade in the same through stock exchanges.

Depending on the associated risk

In the case of an agreement between two parties, there is always a certain level of risk involved. For starters, one of the parties may refuse to abide by the contract during the settlement period. However, in the case of future contracts, it is regulated by the government and stock exchange houses are responsible for handling the agreement between both parties. All of this indicates that there are clearly minimal risks involved in this kind of contract.

Forward contracts are settled only at the time of delivery, and profit/loss is only determined at that point. Therefore, in case of default, the participants can face major financial losses. The risks involved in forward contracts are known as counterparty risks. 

What about the price discovery mechanism?

If we make a comparison between forward and future contracts then we can say that a futures contract offers a more effective price discovery method since it is standardized. As a result, the prices of a futures contract are straightforward and clear. On the other hand, the pricing of the forward contract is solely decided by the two involved parties.

On the basis of maturity and volume of the contract

In contrast to futures contracts, which may or may not occur, forward contracts mature upon the delivery of the product. In futures contracts, the contract size is standardized, however, in forward contracts, it fully is determined by the demand of involved parties.

Depending on the scope, purpose and structure

For forward contracts, the trader or investor does not need to offer any kind of inceptive payment whereas it can also be customized while keeping in mind the trader’s needs. On the other hand, traders need to pay an initial margin fee for future contracts and they are mainly standardized contracts. Forward contracts are mainly used for the hedging process.

Based on the guaranteed returns

As mentioned earlier there is no guarantee of returns on forward contracts because the counterparty risks on forward contracts are significantly high therefore, you can only wait till the maturity period to know anything about the returns. There is little counterparty risk associated with futures contracts, and their value is entirely dependent on market rates and which are settled each day.

The key distinctions between both contracts are listed below:

Contrast typeForward contractFuture contract
Regulated byNo authority involved

Regional market regulator.

(For example, in India it is handled by SEBI)

Date of maturityBased on the terms of the contractOn the predetermined date
Type of settlementPreviously agreed maturity date acknowledged by both partiesContracts are settled daily by the stock exchange
CollateralNo need for initial marginAn initial margin required as per the rules of stock exchanges
Price discovery mechanismPrice is decided by the involved parties Comparatively easy to determine the price

Is there an advantage to futures contracts over forward contracts?

Since futures contracts are transacted on exchanges as opposed to forward contracts, which are discussed in secret between two individual parties, their details are publicly available. Therefore, any trader can access and examine them before thinking about investing in the same. More importantly. futures contracts are typical, thus they have an expiration date along with predetermined terms. Conversely, forward contracts are tailored to the requirements of the concerned parties.

List of most active future contracts (based on currency)

Contract nameSymbolLast traded priceVolume
U.S. Dollar Index (Mar '23)DXH23104.0306,876
U.S. Dollar Index (Jun '23)DXM23103.64019
British Pound (Jun '23)B6M231.20978
British Pound (Mar '23)B6H231.206534,102
Swiss Franc (Jun '23)S6M231.093001
Swiss Franc (Mar '23)S6H231.083505,799
Euro FX (Jun '23)E6M231.07350135
Euro FX (Mar '23)E6H231.0670573,311
Japanese Yen (Jun '23)J6M230.77180036
Canadian Dollar (Jun '23)D6M230.737202

(Price date as per December 23, 2022)

Final words

By now we have successfully been able to distinguish the difference between forward and future contract and every investor or trader should be aware of these differences in order to carefully invest their money on the same. More importantly, every investor should operate only through a reliable brokerage firm or platform while using these financial trading instruments so that they can efficiently access their assets without going through any kind of trouble.

  • What is the benefit of a forward contract?

  • What is the actual difference between currency forwards and futures markets?

  • What are the two types of forward contracts?

  • Forward rate and future rate: how are they different?

  • Tell us the main distinction between hedging and forward contracts.