The main difference between futures and forward contracts is that futures are standardized and traded on exchanges, offering more liquidity and less credit risk. Forwards are private agreements, customizable and traded over-the-counter which lead to higher counterparty risk but more flexibility.
Futures Contract Meaning
A futures contract is a standardized legal agreement to buy or sell an asset at a predetermined price at a specified future date. Traded on exchanges, it’s used for hedging or speculation, offering high liquidity and involving a commitment to transact in financial instruments or physical commodities.
A futures contract is a financial instrument where parties agree to trade a specific asset, like commodities or stocks, at a set price and date. It’s standardized in terms of quantity and quality, ensuring consistency across all contracts.
Traded on organized exchanges, futures provide high liquidity and are often used for hedging risks or speculative investments. They require a margin deposit as security, mitigating credit risk. The futures market is regulated, adding a layer of security for participants.
For Example: Consider an investor who anticipates that the shares of Company XYZ, currently trading at ₹100, will rise. They buy a futures contract for 100 shares at ₹100 (₹10,000 total). If the stock rises to ₹120, the contract is now worth ₹12,000, and the investor profits ₹2,000. If the stock falls to ₹80, however, they face a ₹2,000 loss.
What Is a Forward Contract?
A forward contract is a customized agreement between two parties to buy or sell an asset at a specified future date for a price agreed upon today. Traded over-the-counter and not on exchanges, it’s used for hedging and tailored to the parties’ specific needs and terms.
A forward contract involves a private deal directly between two entities to trade an asset at a future date, at a pre-agreed price. It’s not standardized and is created based on the parties’ specific requirements.
These contracts are traded over-the-counter (OTC), not on formal exchanges. This allows for customization but increases counterparty risk, as there’s no centralized clearinghouse. They’re typically used by businesses to hedge against price fluctuations in commodities or currencies.
For Example: Consider an investor who signs a forward contract to purchase 500 shares at ₹200 each in six months. If the market price rises to ₹250, they pay only ₹100,000 instead of ₹125,000, saving ₹25,000. Conversely, if the price drops, they incur a loss by paying above market value.
Forward Vs Future Contract
The main difference between futures and forward contracts is that futures are exchange-traded standardized agreements with higher liquidity and lower credit risk. In contrast, forwards are customizable, private contracts traded over the counter, offering flexibility but with increased counterparty risk.
| Aspect | Futures Contracts | Forward Contracts |
| Trading Venue | Traded on formal exchanges. | Traded over-the-counter (OTC), not on exchanges. |
| Standardization | Standardized in terms of size and expiration. | Customizable to the needs of the parties involved. |
| Liquidity | Generally higher liquidity. | Less liquid compared to futures. |
| Credit Risk | Lower due to exchange regulation and margin requirements. | Higher as it depends on the counterparties’ creditworthiness. |
| Flexibility | Less flexible due to standardization. | More flexible, tailored to specific requirements. |
| Counterparty Risk | Mitigated by the exchange. | Higher, as there’s no central clearinghouse. |
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Futures Contract Vs Forward Contract – Quick Summary
- A futures contract is an exchange-traded agreement to trade an asset at a set price and date. Standardized for consistency, it’s widely used for speculation or hedging, providing liquidity and a binding commitment for financial or commodity transactions.
- A forward contract is a tailor-made deal between two entities to trade an asset at a future date for a pre-set price. Not exchange-traded but over-the-counter, it offers customization for hedging, suiting unique terms and requirements of the involved parties.
- The key difference is that futures contracts, traded on exchanges, are standardized with greater liquidity and reduced credit risk, while forward contracts, traded over-the-counter, are bespoke agreements offering flexibility but carry a higher risk of counterparty default.
Forward Vs Future Contract- FAQs
1. What is the difference between forward and futures contract?
The main difference is that futures being standardized and exchange-traded, offering liquidity and lower credit risk, whereas forwards are privately negotiated, over-the-counter contracts, more flexible but with heightened counterparty risk due to their bespoke nature.
2. What is a future contract with an example?
An investor might agree to buy 500 shares of a company at ₹100 each, totaling ₹50,000, for a future date. If the stock’s market price rises to ₹120, the contract’s value increases to ₹60,000, yielding a ₹10,000 profit.
3. What is meant by forward contract?
A forward contract is a private, non-standardized agreement between two parties to buy or sell an asset at a specified future date at a price agreed upon today, often used for hedging purposes.
4. What are the types of futures contracts?
The types of futures contracts include commodity futures for trading items like oil and grains, financial futures for currencies and bonds, and index futures for stock indices like the S&P 500 or Nifty 50.
5. Who uses forward contracts?
Forward contracts are used by a variety of entities, including businesses seeking to hedge against price fluctuations in commodities or currencies and investors looking to lock in prices for future transactions in diverse financial assets.
6. What is the difference between forward contract and hedging?
The main difference is that a forward contract is a specific type of financial agreement for buying or selling an asset at a set price in the future, while hedging is a broader strategy to mitigate financial risks, often employing various instruments like forwards, futures, and options.
We hope that you are clear about the topic. But there is more to learn and explore when it comes to the stock market, commodity and hence we bring you the important topics and areas that you should know:
