2024.04.09
2022.11.11 Futures vs Forwards Contracts
Jana Kanehttps://www.litefinance.org/blog/authors/jana-kane/
Diving into the global economy and world of finance can be an exciting journey if you know the purpose of the most popular financial assets: stocks, bonds, currencies, precious metals, and derivatives. While amateur investors prefer to work with the stock market, those who choose to develop their investing skills show interest in advanced tools like financial derivatives, specifically — futures and forwards.
Lack of knowledge can be costly, so before you buy your first contract, let’s learn more about these two types and outline the key differences between them.
The article covers the following subjects:
- What Is a Forward Contract?
- What Is a Futures Contract?
- Difference Between Futures and Forwards Contracts
- Futures and Forwards Contracts: Examples
- Who Trades Futures and Forward Contracts?
- A Final Word
- Forward vs Futures FAQ
What Is a Forward Contract?
Forward contracts, more commonly called “forwards,” are financial agreements concluded between purchasers and vendors. By entering into these financial contracts, the private parties agree to trade a respective asset at a specific price on an agreed-upon future date. The price and the settlement date of a forward are set at the moment the contract is constituted. The settlement date for each forward remains constant, meaning that for the specific underlying asset all forward contracts settle on the day the contract expires.
This category of derivatives forms a private contract between two parties, so they’re never traded on exchanges. Still, their exclusiveness doesn’t affect their flexibility; generally, forwards are not that rigid in their terms and conditions.
Investors often use forwards to hedge possible risks and effectively cut down any asset’s price volatility. Let’s find out how one can mitigate risks by purchasing a forward contract.
In a nutshell, it’s all about the preset price. The terms of a forward agreement, including the forward price, are set from the very beginning and come into effect once the agreement is executed — nothing, whether internal or external factors, can ever change that. So, a forward contract protects its buyer from unfavorable price fluctuations, which can stem from the volatile nature of the market. Here is a good example to help you better understand how it works in reality:
The parties involved in the agreement decide to trade 2,000 barrels of oil. The price of each barrel is set at $50, so the total sum of the deal is $100,000;
Upon the expiry date of the contract, the buyer will have to purchase these 2,000 barrels at a fixed price stated in the agreement, even if the situation in the market has changed and the oil spot price dropped down to $10 per barrel;
The forward contract also ensures that the delivery of the assets (or cash payment) will take place no matter what, according to the terms accepted by the parties.
Due to their private nature, forwards are not easily accessible for retail investors. The forwards market is pretty hard to predict, and none of the details of the agreements are made public; they are typically kept between the contracting parties. Besides, forwards entail disturbing default risk, as there is a high chance that one of the parties will suffer losses.
What Is a Futures Contract?
Future contracts, also known as “futures,” have a lot in common with forwards, as they are also privately negotiated. They oblige the parties to purchase or sell the respective asset at the agreed-upon price on the specified future date. So, a purchaser takes an obligation to buy the underlying asset on the acknowledged conditions, while a vendor pledges to deliver the items on the contract maturity date. Thus, even if the underlying asset rises or falls in value on the spot market when the customized contract expires the parties will buy or sell it at a previously fixed price.
According to the method of mutual settlement, futures can be subdivided into two groups: deliverable and non-deliverable (also known as futures for difference).
In deliverable futures, a buyer undertakes to pay the total cost of an underlying asset, while a seller is obliged to deliver it physically as per the agreement.
Non-deliverable futures entail both parties performing a mutual settlement and paying the difference in price when the contract expires.
However, futures contracts do have some peculiar features that differentiate them from forward contracts.
For starters, futures' fair value is marked to market on a daily basis, meaning that all changes are settled daily until the contract expires. The forward’s price doesn’t change throughout the lifetime of the contract, and the settlement always occurs on the specified date. In contrast to forwards, futures’ settlements can occur over a range of dates.
Another significant difference is that futures are accessible through most exchanges, and the transactions are validated by clearinghouses. Therefore, the risks of default are drastically lowered. Parties generally enter such contracts to trade stocks, currency, and commodities; the most popular assets include crops (e.g., corn, wheat, oat) and subsoil resources like oil.
The highly liquid nature of the futures market enables investors to enter and execute contracts whenever it’s more suitable for them. Futures also often become subjects to speculation when investors try to predict market fluctuations and take advantage of price movements to turn them into profit. Speculators usually execute the contracts prior to their maturity date, so, ultimately, the delivery of the underlying assets rarely happens, as investors choose a cash settlement instead.
Difference Between Futures and Forwards Contracts
As we have already stated above, forward and futures contracts are similar in many aspects, as both contracts constitute agreements to purchase and sell underlying assets on a specific date in the future. They also have a similar price formation, as the prices derive from the related assets that are to be traded upon a contract’s maturity. What about the differences? Let’s examine them in detail below.
Forward Contract | Futures Contract | |
Purpose | A forward contract is one of the favored tools among hedgers. They use the derivative to minimize the impact of the market volatility that can dramatically influence the underlying asset’s price. Cutting down on the volatility becomes possible as the terms of the contract remain unchanged right until the agreement expires, saving the asset from the dangers of price fluctuations. | In contrast to forwards, futures agreements are widely recognized as highly speculative investments, as it’s almost impossible to predict whether the price of an underlying asset will increase or go down. The uncertainty means that if an investor’s conjecture about the price movement is not confirmed, they are exposed to the risk of losing considerable sums of money. |
Transaction Method | Forward contracts are private agreements that are subject to customization, as the terms are negotiated directly by the respective parties. Due to their private nature, they are not available on exchanges and are traded exclusively in the OTC (over-the-counter) market. | Futures are standardized contracts with standardized terms. They don’t allow any private negotiations or adjustments; that’s why these contracts can be quoted and traded on futures exchanges. |
Regulation | A forward contract constitutes a private agreement. The government or financial institutions do not regulate this derivative. | A futures contract constitutes a publicly available agreement. Most futures exchanges are located in the United States; therefore, they operate under the applicable U.S. laws and are always regulated by the government, specifically, CFTC (the Commodity Futures Trading Commission). CFTC is the official governing body created especially for these purposes. |
Risks | Forwards always incorporate high counterparty risk. Furthermore, forward contracts don’t provide any settlement guarantees until maturity. On the other hand, investors can rest assured that the contract will be settled strictly on the delivery date. The major disadvantage is that you never know if you profit or absorb losses until the settlement process is initiated. Hence, the loss can come entirely unexpectedly to the market participants. | Futures attract investors by the guarantee of low counterparty risk, as an asset’s value is settled on a daily basis and tightly connected to the current market rates. More importantly, futures are supported by the clearinghouse of the respective exchange, with the clearinghouse acting as a counterparty for both the parties: seller and purchaser. This, and the fact that futures’ assets are marked to market daily, drastically mitigates all possible counterparty risks. To open a position on a futures exchange, investors need to have margin accounts so they can make an initial payment, also called a margin deposit. At the end of each day, the mutual obligations are recalculated according to the current price set at the closing time of the exchange. Ultimately, the difference between the opening and the closing prices is either credited to the investor's account or debited from it. Such a margin trading system is remarkable for a relatively small initial margin, daily price recalculation, and distribution of the price difference. These features make futures contracts attractive to speculators. However, such peculiarities are also the reason why futures trading is widely recognized as one of the riskiest endeavors in the investment market. |
Expiration Date | A forward's expiration date depends exclusively on the requirements set by the parties for the particular financial transactions. | A future’s expiration date is standardized. |
Maturity Date | Forwards mature upon the delivery of the underlying asset (e.g., such commodities as corn or oil). | Even though futures are standardized and have preset maturity dates, they entail that the delivery of the underlying asset may never happen. |
Contract’s Size | The size of the contract depends on the transaction as well as the requirements of the parties to an agreement. | A futures contract has a standardized size. |
Market | Forwards are mostly traded in a primary market. Due to their confidential nature, forward contracts are often tailored to the specific needs of a particular purchaser and vendor. That means that you will have to overcome the challenge of finding another buyer who has exaсtly the same problem that can be solved by entering an already existing forward contract. | Futures are actively traded in both primary and secondary markets. The standardized nature of futures makes them ideal for trading in a secondary market, as prospective purchasers can simply choose among various offers without studying the terms of each contract. So, futures’ obligations can be easily transferred from one party to another. |
Settlement | The settlement of the forward contracts always happens during the delivery of the underlying assets. Moreover, the parties can find out whether they profited or suffered losses only during the settlement process. | The settlement of futures contracts is not tied up to any specific date. Unlike forwards, this category of derivatives is settled daily (not solely at maturity), implying that futures can be purchased or sold at any moment. |
Nature | Customizable nature: forwards' unique terms are negotiated, quoted, and arrived at between two parties. Customization is a substantial advantage of forward contracts, as it allows the inclusion of additional details and terms, provided the related parties both agree on the provisions. However, the highly customizable nature of forward contracts makes them hard to purchase or sell in the same manner as other derivatives contracts. | Standardized nature: the futures' terms, like delivery dates, contract size, technical features, and transaction procedures, comply with the uniform standard for any kind of futures contract. |
Trading | Forwards are private contracts negotiated and concluded between a purchaser and a vendor. This type of arrangement is traded on the OTC market, so the forward derivatives are not available publicly and are not traded on exchanges. Typically, an everyday trader can't easily access them. | Futures contracts are usually traded publicly on futures exchanges. As it is a standardized contract, futures can be traded through brokers. The futures trading process has lots in common with standard stock trading, as in both cases, the involved counterparties operate the futures trade with the help of their brokerage firms. |
Liquidity | The forward market is characterized by low liquidity. The low liquidity level means that investors, who choose this financial derivative, lack flexibility and can’t enter or exit a forward contract whenever they want to do so. | The futures market is characterized by greater liquidity when compared to forwards. The market creates a beneficial level of liquidity by means of standardization. |
Margin | As forwards don't require initial payments at all, there is no applicable margin system. | Opposite to forwards, futures contracts have a stable margin system that is compulsory to follow. Initial payments are required even for futures with interest rates. As futures are marked to market every day, it's easy to estimate the daily profit or loss incurred by an underlying asset. So, the responsible authority either adds gain or deducts loss from the initial margin (on the effective date of the contract) or from the balance amount kept in the margin account (at the end of each day up until the agreement expires). |
Mark to Market | 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. |
Counterparty | Forwards involve considerable risks for one of the parties. | Futures contracts imply negligible risks for both counterparties. |
Transaction Marking | Transaction markings only occur twice: on the purchase and settlement dates. | Transaction markings are performed daily. |
Default | The default chances in forward contracts are high. | The default chances in futures contracts are either negligible or impossible. |
Cost | Forwards are more expensive. | Futures are less expensive. |
Futures and Forwards Contracts: Examples
To help you better understand the nature of futures and forwards, we decided to provide you with an example of how the derivatives will work under different circ*mstances.
Meet Mark,the main hero of our story and, concurrently, the candy store chain owner specializing in selling desserts with fresh fruit. At the present moment, he purchases fruit, let’s say, mangoes for $5/lb from the same supplier “Paradise Island.” The current market price suits him well, allowing him to maintain a favorable margin on the sale of fruit desserts.
A week ago, Mark read a piece of alarming news on the Internet: a strong tropical cyclone is about to reach the coast of India where Paradise Island’s plantations are located. Meteorologists forecasted that the hurricane could destroy the mango plantations in the area, and now Mark is worried that the price for the fruit will increase.
Forward Contract | Futures Contract | |
Premise | Paradise Island doesn’t share Mark’s worries and claims that its operations are 100% safe. Furthermore, the company has recently purchased brand new equipment and plans to expand the production of mangoes by growing more fruit while keeping the expenses at the same level. Mark and Paradise Island sign a forward contract to keep the price of mangoes at $5/lb, no matter what happens in the next six months. From now on, Mark is legally obligated to buy 10,000 lbs. of mangoes at $5/lb ($50,000 for six months). Paradise Island is compelled to sell fruit under the negotiated terms even if typhoons devastate its plantations. | Paradise Island offers mango futures at the price of $150 per contract. Each contract expires six months from the effective date. Mark decides to purchase 500 of the mango futures, with the size of one contract equaling 30 lbs of fruit. The overall price is $75,000 for 15,000 lbs ($5 for lb). The profound industry analysis shows that if the cyclone danger passes, equipment advancements will boost mango production, and fruit suppliers will harvest 30% more mangoes. |
Scenario: Plantations are destroyed | Plantations are destroyed, and the supply of mangoes reduces significantly. Paradise Island has to cover losses by raising the price of mangoes to $8/lb. The total transaction for six months is now worth $80,000, but Mark only pays $5/lb and realizes $30,000 in cost savings. Paradise Island suffers considerable financial losses. | Next week, a massive natural disaster impoverishes mango plantations on the Indian coast. The price of a mango futures contract spikes to $180 per item. Futures are derivative contracts, meaning they derive their value from the current mango value, so one can deduce that the price of mangoes has substantially increased. In this scenario, Mark has profited and made a $15,000 capital gain by selling the contracts to another party, as his futures are now worth $90,000. |
Scenario: Cyclones passed over the plantations | The cyclone disaster never happened, and Paradise Island benefited from utilizing new equipment. Now the market is flooded with mangoes. As the supply of fruit drastically increases, the company reduces the price to $3/lb. Mark still has to buy 10,000 lbs. of mangoes but overpays $2 for each lb. Paradise Island realizes a good profit of $20,000. | The financial analysts' predictions came true, and the industry is booming, producing more mangoes than usual. The current market price of mango futures goes down to $100 per item. In this scenario, Mark has suffered a considerable capital loss of $25,000; he owns the futures worth only $50,000, while their initial cost was $75,000. Mark can still sell his contracts and invest the proceeds in something else to cover the losses. |
Who Trades Futures and Forward Contracts?
Investors, who trade these financial derivatives, can be classified into two major categories. This subdivision is based on the fundamental motive of a trader.
Forwards: Hedging
Hedgers’ urge to mitigate possible risks is easy to understand. This class of investors is eager to reduce the impact of market fluctuations that can seriously affect the underlying asset’s price. Hedgers buy forward contracts to cut back on an underlying asset's cost volatility. As the terms of the forward remain unchanged until the contract expires, it is not influenced by market volatility at all. So, if counterparties conclude an agreement to sell 5,000 lb of wheat at $5 for lb ($25,000 in total), the terms will remain in force even if the wheat price decreases to $1 per lb. Forwards ensure either the physical delivery of the underlying assets or an appropriate cash settlement if both parties accept such a decision.
Futures: Speculation
Speculators usually opt to enter a financial agreement rather than purchase the asset they need. Such a move excuses them from paying the total value of assets and, at the same time, enables them to magnify the potential gains. So, speculators frequently buy derivatives, trying to predict the possible movement of the underlying asset's price. If they succeed in guessing the direction of this movement, they prefer to close out before the contract matures. Typically, speculators are not interested in the delivery of the assets and choose a cash settlement instead.
A Final Word
Expanding investment horizons becomes possible with advanced financial instruments like derivatives. While many risk-averse investors prefer to work predominantly with more familiar tools, such as stocks and bonds, one can benefit from going further and discovering new methods of income generation.
Now that you know the basics of how forwards and futures work, you can give them a shot. For instance, LiteFinance offers its clients a great opportunity to try their hand at oil futures trading. However, it's essential to consider the potential risks (they never go away!) and how both of these two derivatives are executed. Futures and forward contracts may become a good option for both hedgers and speculators, but you still need to conduct deep market research before advancing into action.
Forward vs Futures FAQ
They can be so. However, when compared to forwards, futures are far more beneficial in terms of low counterparty risks. In futures, an underlying asset’s value settles daily and changes according to the relevant exchange rates. Furthermore, futures are governed by the clearing houses that act as a counterparty for both parties.
The main advantage of futures is that these contracts are standardized, so you can assess them almost on every licensed futures exchange. Some other advantages include:
- Negligible default chances
- Flexibility (you can enter and sell futures at any time)
- Daily settlement
- Publicity
- High liquidity
- Low counterparty risks
- Presence in the secondary market
Yes, futures contracts are settled daily. That means these derivatives can be bought or sold at any time - you know the current price and can work with this information. Futures' settlement is not tied to a specific date, which makes them more flexible financial tools than forwards that are settled only at maturity.
Unfortunately, they can. Futures can both gain and lose value over time depending on the situation on stock exchanges. Suppose you purchased 100 cane sugar futures at the price of $20 per contract. The supplier hired more employees and bought new equipment that allowed them to increase the volume of cane sugar production. Now 100 contracts are worth $10 per item, and you lost $1,000.That’s how futures work.
Futures contracts are derivatives, meaning that their value depends on the value of the underlying assets. While futures are highly standardized and generally entail lower counterparty risks, they are still exposed to the market risk caused by price fluctuations as well as credit risk related to margin trading. However, in contrast to forwards, which oblige you to follow the provisions until the contract expires, you can resell your futures contract whenever you want to do so.
Yes, they are. Just like any other financial derivative, a forward “derives” its value from the value of the asset that underlies the contract. Though it’s available only off exchange, a forward contract can be traded over the counter (OTC). However, unlike other types of derivatives, there is no initial payment required and no stock exchange is involved. Instead, the contract is between two parties and is typically only used by institutional investors. In most cases, there is also an institutional guarantee from a third party, such as a bank, to ensure that the contract is fulfilled.
The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.
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