Key Difference Between Future and Forward Contracts - [Derivatives Market]

1. Forward contracts vs Futures

Forward contracts are OTC contracts which means that they are traded Over the Counter. These are not standardized contracts are therefore are not traded on the exchanges. The OTC nature of these contracts makes it easier for the users to customize terms. However, there is a high level of default risk associated with these contracts due to the lack of a centralized clearing house.

Forward contracts can be customized as per the need based on the underlying asset, amount and delivery date. Forward contracts are not easily available to retail investors when compared to the futures contracts.

Forward contracts and futures contracts are very much similar in nature. Both forwards and futures contracts involve buying or selling an underlying asset at a set price in the future. The key point which differentiates forward contract from futures is that forward contracts are not traded on the exchange. Forward contracts are settled at the end of the contract tenure, whereas the profit and loss for futures contracts is set on a daily basis. Above all, the main highlight with futures contracts over forward contracts is that futures are standardized contracts which are not customized unlike futures between counter parties.

2. Head to Head Comparison

Let us now have a look at a head to head comparison between forward contracts and future contracts based on various parameters.

Futures contracts can be cash settled or may require physical delivery depending on the contract and the exchange. Mostly future contracts are from those traders who speculate on trade. These contracts are closed out and netted, which means that the difference between the original trade and closing trade price is calculated and the contracts are cash settled.

Purpose – Futures contracts are mainly used for speculation whereas forward contracts are used for hedging purposes.

Transaction Methods – Future contracts are traded on the derivative exchanges. On the other hand, forward contracts are over the counter instrument and are not traded on any exchange.

Regulation – Future contracts are regulated contracts governed by the Commodity Futures Trading Commission. Forward Contracts are unregulated contracts which makes them riskier when compared to Futures.

Expiry Date – Futures Contracts have a standardized expiry date whereas the expiry date for Forwards Contracts depend on the transaction.

Level of Incurred Risks – Futures Contracts are standardized contracts and therefore carry a lower counterparty risk. The counterparty risks in case of Forward Contracts is relatively very high.

Maturity of Contract – Futures Contracts may or may not mature on the delivery of the financial asset, but Forward contracts necessarily mature on the delivery of a financial asset.

Size of the Contract – Futures have a standardized contract size. However, in case of forward contracts, the size of the contract depends on the transaction as well as the requirements of the parties from the agreement.

Settlements – Futures are settled on a day to day basis whereas Forward contracts are settled only once, on the date of maturity.

Liquidity – Futures offer a high rate of liquidity. Forward contracts have a relatively lower liquidity rate due to the OTC nature.

These were some of the key parameters for comparing forward contracts and derivative contracts, which can help you in getting a detailed idea about the differences between these two derivative instruments.

While forward contracts are not available easily for the retail investors, they do carry a high amount of risk associated with them. Therefore, you can invest in futures contract instead which work very much similar to Forward contracts. You should get your risk profile evaluated from a SEBI registered investment advisor before investing in any of the investment instruments to have an idea about your risk bearing capacity.