Know the difference between a futures contract and a forward contract
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 type | Forward contract | Future contract |
| Regulated by | No authority involved | Regional market regulator. (For example, in India it is handled by SEBI) |
| Date of maturity | Based on the terms of the contract | On the predetermined date |
| Type of settlement | Previously agreed maturity date acknowledged by both parties | Contracts are settled daily by the stock exchange |
| Collateral | No need for initial margin | An initial margin required as per the rules of stock exchanges |
| Price discovery mechanism | Price 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 name | Symbol | Last traded price | Volume |
| U.S. Dollar Index (Mar '23) | DXH23 | 104.030 | 6,876 |
| U.S. Dollar Index (Jun '23) | DXM23 | 103.640 | 19 |
| British Pound (Jun '23) | B6M23 | 1.2097 | 8 |
| British Pound (Mar '23) | B6H23 | 1.2065 | 34,102 |
| Swiss Franc (Jun '23) | S6M23 | 1.09300 | 1 |
| Swiss Franc (Mar '23) | S6H23 | 1.08350 | 5,799 |
| Euro FX (Jun '23) | E6M23 | 1.07350 | 135 |
| Euro FX (Mar '23) | E6H23 | 1.06705 | 73,311 |
| Japanese Yen (Jun '23) | J6M23 | 0.771800 | 36 |
| Canadian Dollar (Jun '23) | D6M23 | 0.73720 | 2 |
(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?
As a seller, you can certainly benefit from a forward contract because you will have the opportunity to fix the price for a specific asset. With the guarantee that you will be able to sell a specific asset at a target price of your choosing, you will be able to control the risk associated with your investment. Forward contracts also enable the buyer to fix the price of the asset they are going to purchase.
What is the actual difference between currency forwards and futures markets?
The main difference between future and forward contracts is that forward contracts have configurable parameters and are traded over the counter. On the other hand, futures contracts have standardized conditions which mean traders and investors can only trade them in stock exchanges.
What are the two types of forward contracts?
There are mainly two types of forward contracts which are known as Option Forward contracts and Fixed Date Forward Contracts. Mainly the purchasing and selling of foreign currencies take place through Fixed Date Forward Contracts (which as the name suggests has a fixed date of maturity).
Forward rate and future rate: how are they different?
Although both futures contracts and forward contracts offer you the option to freeze the exchange rate of the underlying asset until the upcoming due date arrives. However, in a forward contract, the forward rate is something that you can seal in the present time whereas in the future rate it is something that the other party has agreed to pay when you choose to sell the contract.
Tell us the main distinction between hedging and forward contracts.
As an investor, you need to have margin money in order to hold your position in the future market whereas for forward contracts you won’t have to use margin deposits. If we are to talk about hedging then you need to remember that there are lots of extra costs involved in the same such as interest on margin funds, additional marketing costs, the commission of the brokerage platform, etc.