Difference between Forward Contracts and Future Contracts

Forward Contract: It is a type of forward commitment contract which is traded in over the counter exchange. The forward contract is an agreement between two parties in which, the buyer agrees to buy from the seller, an underlying asset at a future date at a price established at the start. The parties to the transaction specify the forward contract’s terms and conditions, such as when and where delivery will take place and the precise identity of the underlying.

In this sense, the contract is said to be customized or tailor made. Each party is subject to the possibility that the other party may default. Forward contracts are the over the counter contract, which don’t have a clearing house between the parties.
Forward contracts are been traded in a private and unregulated market, where banks, investment banking firms, government and large corporations trade with each other. For example, IT companies generally enter into forward contracts to lock the exchange rate of currencies, in order to preserve there profits. If locking of exchange rate is not done, than the profit can be diminished due to fluctuations in exchange rate. 
These contracts are unregulated and private because the parties don’t want much of the government interference in it. But it doesn’t mean that there is something illegal in the contract. The contract are private because the parties don’t want to disclose much about the customized contracts. This is the reason why are don’t get information about forward contract in business magazines or newspaper.

Future Contracts: A futures contract is a variation of a forward contract that has essentially the same basic definition but some additional features that clearly distinguish it from a forward contract. For one, a futures contract is not a private and customized transaction. Instead, it is a public, standardized transaction that takes place on a futures exchange.

Forward contracts and future contracts are having some basic differences. Below is the list of 10 most important differences between forward contracts and future contracts.

1 Standardized contracts Customized or tailor made contracts
2 Publically traded Traded privately
3 Daily settlement of profit and loss, which is known as mark to market. The profit or loss is accumulated till the expiry of contract
4 Trades at future exchange Trades at over the counter exchange
5 No default risk Rare default risk exist
6 Clearing house takes the responsibility of defaults and pay to the other party. No Clearing house is present between the parties in forward contract
7 Future contracts are open to general public as they are traded on future exchanges. Financially sound and creditworthy parties only can enter into forward contracts.
8 Parties have indirect contracts between them, as exchange write a contract in between both parties.  The exchange collect the payment from one party and transfer to other party. Both parties have direct contract between them, and payments are also handled by them independently as per there own terms and conditions.
9 Parties can anytime enter into opposite transactions before expiry. Forward contract are generally intended to be in force till maturity, however,
it is possible for party to enter into opposite transaction before expiry.
10 Futures markets offer the parties liquidity, which gives them a means of buying and selling the contracts.  Because of this liquidity, a party can enter into a contract and later, before the contract expires,
enter into the opposite transaction and offset the position, much the
same way one might buy or sell a stock or bond and then reverse the transaction later.
Since forward markets are intended to be in force till maturity, so they don’t provide liquidity.

Leave a Reply

Your email address will not be published. Required fields are marked *