Forward Contracts vs. Futures Contracts: What’s the Difference? (2024)

Forward and futures contracts are derivatives that involve two parties who agree to buy or sell a specific asset at a set price by a certain date in the future. Buyers and sellers can mitigate the risks of price changes by locking them in advance.

A forward is made over the counter (OTC) and settles just once—at the end of the contract. Both parties involved in the agreement privately negotiate the contract's exact terms. Forwards carry a default risk since the other party might not come up with the goods or the payment.

Futures contracts, meanwhile, are standardized to trade on stock exchanges. As such, they are settled daily. These arrangements come with fixed maturity dates and uniform terms. They have far less counterparty, as they guarantee payment on the agreed-upon date.

Key Takeaways

  • Forward and futures contracts involve two parties agreeing to buy and sell an asset at a specified price by a specific date.
  • A forward contract is a private, customizable agreement that settles at the end of the agreement and is traded over the counter (OTC).
  • A futures contract has standardized terms and is traded on an exchange, where prices are settled daily until the end of the contract.
  • There is less oversight for forward contracts as privately negotiated, while futures are regulated by the Commodity Futures Trading Commission (CFTC).
  • Forwards have more counterparty risk than futures.

Forward Contracts

Forward contracts are privately negotiated agreements between a buyer and a seller to trade an asset at a future date at a given price. They don’t trade on an exchange and have more flexible terms and conditions, including the amount of the underlying asset and how it will be delivered. Forwards have one settlement date: the end of the contract.

Many hedgers use forward contracts to reduce the potential volatility of an asset’s price. Since the terms are set when they are executed, forward contracts don't fluctuate in price. That means if two parties agree to the sale of 1,000 ears of corn at $1 each (for a total of $1,000), then the terms cannot change even if the price of corn goes down to 50 cents an ear.

Forwards are not readily available to retail investors, and the market for them is often hard to predict. That’s because the agreements and their details are generally kept between the buyer and the seller, and are not made public. Since they are private agreements, there is a higher degree of counterparty risk, which means there may be a chance that one party will default.

Futures Contracts

Like forwards, futures contracts involve agreeing to buy and sell an asset at a specific price at a future date. These contracts are marked to market daily, which means that daily changes are settled daily until the end of the contract. The futures market is generally highly liquid, giving investors the ability to enter and exit whenever they choose to do so.

These contracts are frequently used by speculators looking to profit from an asset's price moves. Speculators typically close their contracts before maturity and delivery usually never happens. In this case, a cash settlement usually takes place.

Because they are traded on an exchange, exchanges partner with clearinghouses that act as the counterparty when you go to buy futures through your broker. This drastically lowers the chances of default. As of 2024, the most traded futures were in equities (65% by volume), currencies (9%), interest rates (9%), energy (5%), agriculture (4%), and metals (4%).

Key Differences Between Futures and Forwards

Futures are overseen in the U.S. by the Commodity Futures Trading Commission (CFTC), the Financial Industry Regulatory Authority, nongovernmental Futures Industry Association, individual exchanges, clearinghouses, and brokers. The CFTC was established in 1974 to regulate the derivatives market, to ensure the markets run efficiently, and to protect investors from fraud and consumers from market manipulation.

It's often been said that forwards are largely unregulated since they are one-on-one contracts. That was never quite right since myriad federal, state, and local laws attach to both contracts and specific underlying assets. But that's clearly no longer the case. Changes after the 2007-8 financial crisis and new regulations in the past decade have brought greater transparency to the OTC market. Nevertheless, forward contracts come with fewer safeguards. Meanwhile, futures are backed by clearinghouses. Unlike forwards, where there is no guarantee until the contract is settled, futures require a deposit or margin. This acts as collateral to cover the risk of default.

The underlying assets associated with forward and futures contracts include financial assets (stocks, bonds, currencies, market indexes, and interest rates) and commodities (crops, precious metals, and oil- and gas-related products).

Forward Contracts vs. Futures Contracts Example

To see how these types of derivatives work, let’s look at two examples for comparison.

Forward Contracts

Suppose a producer has an abundant supply of soybeans and is concerned that the commodity’s price will drop soon. To hedge the risk, the producer negotiates with a financial institution to sell three million bushels of soybeans for $6.50 per bushel in six months. Both parties agree to settle the contract in cash.

The outcome of this contract for soybeans can vary in these ways:

  • The future price is exactly as contracted. The contract is settled per the agreement, and neither party owes the other any money.
  • The price is lower than the negotiated price. Let’s say the price drops to $5 per bushel, but the settlement still goes through at the agreed-upon price. This means that the producer’s bet to hedge the risk of a price drop works.
  • The price is higher than the agreed-upon price. The contract is settled at the negotiated price, even though the producer may have profited from a higher cost per bushel.

Futures Contracts

Oil producers often use futures to lock in a price and then proceed with delivery once the expiration date hits. Suppose Company A is afraid that demand will slow, affecting the price of oil on the market, which in turn will impact the company's bottom line. The company enters into a futures contract to lock in the oil price at $75 a barrel, believing it will drop in six months.

If demand drops and the price sinks to $65 per barrel, Company A can still settle the contract at the original contract price of $75 per barrel, making a profit of $10 per barrel. However, should the price of oil go to $85 a barrel, Company A will lose out on the $10-per-barrel profit, though it was still protected from the financial crisis it might face should oil go down by a lot.

Forwards vs. Futures

Forwards

  • Trade OTC

  • Customizable terms

  • Often no upfront cost

  • Higher counterparty risk

Futures

  • Trade on listed exchanges

  • Standardized terms

  • Contracts must be paid for with an initial margin

  • Very low counterparty risk

What Is Margin in Futures Contracts and How Is It Different For Forward?

Margin in futures contracts refers to the initial deposit required to enter into a contract, as well as the maintenance margin needed to keep the position open. This system of margining helps manage the risk of default by ensuring that participants have enough funds to cover potential losses. By contrast, forward contracts do not typically require margin, as they are private agreements with the risk managed through checking the creditworthiness of the parties involved.

When Would A Trader Prefer a Forward to a Futures Contract and Vice Versa?

A trader or investor might prefer a forward contract when they require a customized agreement to hedge specific risks or when dealing with commodities or assets that are not standardized. Forwards are also worthwhile for parties seeking privacy. Conversely, a futures contract might be preferred for its liquidity, ease of access, and regulatory oversight, making it suitable for speculation or hedging in more standardized and transparent markets.

What Are the Main Disadvantages of a Forward Contract?

There are several key disadvantages of a forward contract. For instance, their details are not made public, as they are negotiated privately between the two parties involved and because they trade over the counter. They offer more flexibility but also have higher counterparty risk. The regulatory environment can significantly impact the choice between forwards and futures, depending on the trader's or investor's risk tolerance and compliance requirements if trading for a firm.

The Bottom Line

Forward contracts are made privately between two parties over the counter and settlement dates and what's exchanged at maturity are set, not marked to market. Since the forward contract is negotiated between two counterparties, there is the risk that one of them may default and not fulfill the agreement's terms, known as counterparty risk. On the other hand, a futures contract is a fixed contract traded on a futures exchange, like the New York Mercantile Exchange, which has margin requirements that back up the futures contract, essentially eliminating counterparty risk. Futures contracts are also traded when the exchange is open and can be marked to market in real-time

What futures and forwards have in common is the ability to lock in a set price, amount, and expiration date for the exchange of the underlying asset.

Forward Contracts vs. Futures Contracts: What’s the Difference? (2024)

FAQs

Forward Contracts vs. Futures Contracts: What’s the Difference? ›

A forward contract is a private, customizable agreement that settles at the end of the agreement and is traded over the counter (OTC). A futures contract has standardized terms and is traded on an exchange, where prices are settled daily until the end of the contract.

What is the basic difference between forward and futures contracts? ›

Here are some important differences between them. A forward contract is signed between party A and party B face to face (or over the counter), whereas in a futures contract there is an intermediary between the two parties. This intermediary is often called a clearance house, which is a part of a stock exchange.

What is the difference between a forward market and a futures contract? ›

The futures market is an exchange-traded market, whereas the forward market is an OTC market. This implies that contracts on the currency futures market are often structured by exchanges and guaranteed by their clearing business. Since it is a guaranteed market, there is no counterparty risk in the futures market.

How are futures contracts priced differently from forward contracts? ›

Unlike forward contracts, futures contracts are marked to market daily. As futures prices change daily cash flows are made, and the contract rewritten in such a way that the value of future contracts at the end of each day remain zero.

What is the difference between bond futures and forwards? ›

Bond futures are subject to daily cash settlement. A bond forward is an OTC contract that can be customised to suit individual needs. Also included under OTC contracts are transactions derived form reference contracts based on bond futures, but which cannot be fitted to individual needs.

What are three major differences between forward and futures? ›

Structure, Scope And Purpose

While futures are highly liquid, forwards are typically low on liquidity. ETF Futures are typically more active in segments, like stocks, indices, currencies and commodities, while OTC Forwards usually sees larger participation in currency and commodity segments.

Why use futures instead of forwards? ›

Forwards are never marked to the market. Their distinctive features are exclusiveness and a specified price. Futures are marked to market daily, meaning they are settled every day until the contract's expiration date. Forwards involve considerable risks for one of the parties.

What is one big difference between futures and forwards? ›

A forward contract is a private, customizable agreement that settles at the end of the agreement and is traded over the counter (OTC). A futures contract has standardized terms and is traded on an exchange, where prices are settled daily until the end of the contract.

Are forwards cheaper than futures? ›

If futures prices are positively correlated with interest rates, then futures prices will exceed forward prices. If futures prices are negatively correlated with interest rates, then futures prices will be lower than forward prices.

What is an example of a forward contract? ›

Under the contract, a specified asset is agreed to be traded at a later date at a specified price. For example, you enter into a contract to sell 100 units of a computer to another party after 2 months at Rs. 50,000 per unit. You enter into a forward contract.

What are the two types of forward contract? ›

Forward Contracts can broadly be classified as 'Fixed Date Forward Contracts' and 'Option Forward Contracts'. In Fixed Date Forward Contracts, the buying/selling of foreign exchange takes place at a specified future date i.e. a fixed maturity date.

What are the advantages of forward contract? ›

The primary advantage of a forward exchange contract is it assists the parties involved in risk management. The certainty provided by the contract helps a company project cash flow and other aspects of business planning.

How do futures contracts work? ›

Futures are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. 2 Here, the buyer must purchase or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date.

Are forwards more flexible than futures? ›

The forward contracts are flexible since they are customized between two parties. The parties can therefore agree in many aspects as opposed to futures which are standardized and can not be changed in the short term.

What is future contract with example? ›

Futures contract example

You can enter into a futures contract to sell a specific quantity of wheat at a fixed price to a buyer, say, six months from now. If the price of wheat falls below the contract price when the contract expires, you benefit because you get to sell your wheat at a higher price.

What are the pros and cons of futures trading? ›

The most prevalent benefits include simple pricing, high liquidity, and risk hedging. The primary disadvantages are having no influence over future events, price swings, and the possibility of asset price declines as the expiration date approaches.

What is one of the main differences between futures contracts and forward contracts quizlet? ›

The main difference between a futures contract and a forward contract is that with the former, buyers and sellers realize gains or losses on the settlement date, while the latter requires that gains or losses are realized daily.

How is a futures contract different than a forward contract quizlet? ›

futures contracts are personalized, unique contracts; forwards are standardized. C. futures contracts are marked to market daily with changes in value added or subtracted from buyer and seller.

How does a futures contract differ from a forward contract quizlet? ›

The price of the asset exchanged is determined when a forward contract is entered while the price is set on the exchange date for a futures contract.

What are the key differences between option and futures contracts explain at least 3 differences? ›

Options are more flexible and customizable than futures. Futures are more standardized and regulated than options. Options can be exercised anytime before expiration (American style) or only at expiration (European style). Futures can be settled by delivery of the underlying asset or by cash settlement at expiration.

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