Technical Analysis
The Difference Between Futures Contracts and Forward Contracts
Similarities:
Futures and forward contracts are both financial derivatives that allow parties to agree on the purchase or sale of an underlying asset at a specific future date for an agreed-upon price. Essentially, a futures contract is a standardized version of a forward contract. Additionally, these contracts can be applied to various types of underlying assets, including commodities (such as oil, silver, wheat), financial assets (such as stocks, bonds, currencies), and market indices.
However, there are fundamental differences between these two types of derivative contracts:
In terms of the trading market, futures contracts are traded on centralized exchanges, while forward contracts are traded over-the-counter (OTC). Futures contracts are standardized in terms of quantity, quality, delivery time, and other conditions, whereas forward contracts are not standardized, with the terms negotiated between the two parties. As a result, the size of a futures contract is fixed by the exchange, while the size of a forward contract is more flexible and can be adjusted according to the agreement between the parties.
The price of the underlying asset in a futures contract is publicly disclosed, competitively determined, and directly auctioned on exchanges or centralized markets. In contrast, the price of the underlying asset in a forward contract is agreed upon privately between the buyer and seller and is not publicly disclosed.
In terms of settlement, futures contracts are settled daily based on the market value (mark-to-market), whereas forward contracts are settled at maturity when the two parties exchange the underlying asset or make a cash settlement.
Futures contracts also have higher liquidity compared to forward contracts due to the larger number of participants and greater transferability. Forward contracts have lower liquidity because they are private agreements between two parties and are not easily transferable.
Regarding collateral requirements, futures contracts require margin payments to the exchange, and if the market price changes, additional margin may be required. In contrast, forward contracts typically do not require margin payments, with collateral obligations depending on the agreement between the two parties.
Futures contracts are also subject to strict regulation by authorities and exchanges, while forward contracts are generally not as tightly regulated by regulatory bodies.
Finally, futures contracts have lower credit risk because they are backed by the clearinghouse of the exchange, which ensures the contract's fulfillment. In contrast, forward contracts have higher credit risk since they lack the backing of a clearinghouse.
Below is a summary of the key differences between futures contracts and forward contracts:
Forward Contract | Futures Contract |
Directly traded between buyer and seller | Traded on Commodity Exchanges |
Not standardized; contract terms can be adjusted according to the needs of both parties. | Standardized by the Commodity Exchange. |
Settled at the contract's maturity when both parties engage in the delivery process. | Settled daily after each trading session based on the market value (Mark to Market) |
Primarily involves the physical delivery of goods or cash settlement at contract maturity. | Positions are primarily closed before the contract's maturity. |
Low liquidity | High liquidity |
Involves various risks such as counterparty risk and settlement risk. | Almost no counterparty or settlement risk due to management through margin and clearinghouse mechanisms. |
Source: Multiple sources