Difference between Forward Contract and Future Contract

Key Difference: A forward contract is a non-standardized contract that allows parties to customize how they want to sell or buy an asset, at which price and what date. On the other hand, a future contract is a standardized contract that requires futures exchange to act as an intermediary between the buyer and the seller for purchasing and selling an asset at a certain date in the future and a specified price.

The world of trading is a confusing one, with many unclear concepts and so many different terms. It is understandable to lose track of so many different words and ideas because of the vast knowledge required to completely comprehend the workings of the trading market. Forward contract and Future contract are two different types of trading contracts that are used to trade a certain commodity in the future at a fixed price and delivery date.

Both the contracts are similar in nature because they both offer the same function: the ability to buy and sell a specific type of asset at a specific time and price. However, they differ when it comes details of how each obligation is fulfilled.

A forward contract is a non-standardized contract that allows parties to customize how they want to sell or buy an asset, at which price and what date. On the other hand, a future contract is a standardized contract that requires futures exchange to act as an intermediary between the buyer and the seller for purchasing and selling an asset at a certain date in the future and a specified price.

The main difference between the two contracts are the rigid structure of the future contract that does not allow for many customizations. While, the forward contract is more of a private agreement between two parties that allow the contracts to be customized any way the parties agree on.

This results in a higher risk factor with the forward contracts, because of the lack of mediating party. In terms of a future contract, the futures exchange acts as the mediator – wherein the parties are not exactly selling or buying from each other but directly from the exchange.

The need for goods in exchange of money or other goods has allowed the market to flourish. The world has evolved from originally using word of mouth for bartering to signing agreements to determine the price of goods and delivery date. The concept gained popularity because of the farmers, where they would receive guarantee that they would be paid for their crops at certain rate when they are harvested. Similarly, the customer would have guarantee that he would be given the product at a certain price when harvested.

However, not always were contracts and agreements kept. Hence, rose the need for a future contract where future exchange managed all transactions and contracts. They also charge a minimal amount that is required to be paid to the exchange, known as the initial guarantee fee. This helped reduce the risk of the parties defaulting on their payments or providing the goods.

Lastly, the purpose each contracts are used for differ. Forward contracts are commonly used for hedging, while the future contracts are used for speculation.

Comparison between Forward Contract and Future Contract

 

Forward Contract

Future Contract

Definition

An agreement between two parties to buy or sell an asset at a pre-agreed date in the future at a specified price

A standardized contract that is traded on a futures exchange to buy or sell an underlying instrument at a certain date in the future and a specified price

Structure

Customized according to the needs of the client

Is standardized

Traded

Negotiated by the buyer and the seller

Quoted and traded on the exchange

Regulations

Not regulated

Government regulated market

Institutional Guarantee

Contracting parties

Clearing House

Risk

High risk

Low risk

Guarantee

No guarantee of settlement until the date of maturity

Both parties must deposit an initial guarantee (margin)

Maturity

Forward contracts generally mature by delivering the commodity

Future contracts may not necessarily mature by delivery of commodity

Pre-termination

Opposite contract with same or different counterparty. Counterparty risk remains while terminating with different counterparty

Opposite contract on the exchange

Expiry

Based on the transaction

Standardized

Size

Depending on the contract and the client needs

Standardized

Market

Primary and  Secondary

Primary

Settlement

Occurs at the end of the contract

Daily changes are settled day by day until the end of the contract

Employed by

Hedgers

Speculators

Image Courtesy: combank.net, svtuition.org

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