Difference Between Forward and Futures Contract

Imagine a world where we can navigate to the future with a bit of certainty and understanding; that’s the world of currency derivatives. In this chapter, we will explore two key instruments used in the financial markets: Forwards and Futures. These tools are navigational aids for traders and businesses, supporting them in the erratic fluctuations of currency rates.

By the end of this chapter, you should have a good understanding of what Futures and Forwards are and how they can be used by big corporations or even individuals or small businesses to mitigate against the unstable movements in foreign exchange rates.

Let’s begin with a more in-depth explanation of forward contracts.

Forward Contracts

A Forward Contract refers to an agreement between two parties to either buy or sell an asset at a predetermined price on a future date. Forward contracts are private and thus allow more flexibility. These tools are widely employed by businesses and investors to offset risks occurring in the course of price changes.

Suppose you are an owner of a small-scale company in India that imports electronic parts from China. The deal is worth one lakh Chinese Yuan, and you'll need to pay in three months. You fear that the Indian Rupee could weaken from the Yuan in this period, making the deal more costly to you. In order not to expose too much to the price risk, you go into a Forward Contract with the bank. The bank undertakes to sell you 1 lakh Yuan in three months, fixing the rate today. In this case, the exchange rate fluctuation doesn’t influence your cost, as it is already predictable.

Forward Contracts help businesses and individuals manage risks by locking in prices. However, they also have disadvantages and a set of risks. We’ll look at them later in this chapter. For now, let’s see what are some key characteristics of forward contracts. 

Characteristics of Forward Contracts 

Here are some of the key characteristics that define forward contracts: 

1. Customisation and flexibility

The most distinctive feature of Forward Contracts is their ability to be tailor-made. Unlike standardised Futures Contracts, Forwards can be customised in terms of the contract size, the asset involved, and the settlement date. This flexibility allows parties to match their specific financial needs and obligations precisely.

2. Over-the-counter (OTC) nature

Forward Contracts are not traded on organised exchanges but are instead negotiated directly between two parties, typically with a bank or a financial institution acting as one of the parties. This over-the-counter (OTC) nature means they are less regulated, offering more privacy and increasing counterparty risk.

3. Counterparty risk

The private nature of Forward Contracts makes it possible for the parties to default on their obligations, the potential for counterparty risk. While this risk is common in the absence of a clearinghouse, it is not usually observed in standardised contracts such as Futures.

4. Settlement and delivery

Forward Contracts can be settled in two ways: to be delivered either in the form of the asset or in a cash payment. It is provisionally set during the contracting. Most of the commodity forwards are financed by physical delivery, while financial forwards are usually settled in cash.

5. No intermediary or centralised clearing

Unlike Futures, Forward Contracts do not involve an intermediary or centralised clearinghouse. This absence can lead to increased credit risk but also means fewer fees and a more straightforward process for the parties involved.

6. Price and rate determination

The pricing of Forward Contracts is typically based on the spot price of the asset, adjusted for time, interest rates, and other factors like storage costs for commodities. This results in a forward price or rate that reflects the market's expectations of future price movements.

Now that we have some understanding of forward contracts let’s see what future contracts mean – so that you have a better picture of how these two types of contracts stand against one another. 

Futures Contracts

Futures contracts are standardised agreements traded on an exchange to buy or sell an asset at a predetermined price at a specified time in the future. These assets can be commodities, currencies, stocks, or financial instruments. The efficiency of futures contracts lies in their standardisations and the presence of a clearing house that hedges against default by either party.

Picture the future as an arranged marriage that is to be done at a certain predetermined date. Parties agree to tie the knot (execute the contract) on that date, regardless of the market situation.

Some benefits of futures contracts include: 

• Businesses use futures to protect against adverse price movements.
• Traders can speculate on price movements to make a profit.
• Futures markets help in determining the future price of an asset.
• Since only a margin is required, traders can control large positions with a relatively small amount of capital.

However, there are some risks involved, too. We’ll get to that in a later section of this chapter! 

Characteristics of Futures Contracts 

Futures contracts are unique financial instruments with specific characteristics that set them apart from other types of investments. Understanding these traits is essential for anyone looking to engage in futures trading or use them for risk management.

1. Standardisation

Futures contracts are highly standardised. This thus entails that all the details in the contract – the quantity, quality and time of delivery of the asset/underlying asset – should have been known before the trade. Thus, a gold futures contract on a particular stock exchange may represent 100 troy ounces of 99. 5% pure gold, for instance.

2. Margin and leverage

Future trading needs a margin, which is a portion of the whole contract's worth. The margin is a performance bond so as not to deposit a down payment because the trader may cover the loss. Leverage, on the other hand, is a crucial aspect of futures trading, as it allows traders to control a large position with a relatively small amount of capital. While leverage can amplify profits, it also increases the potential for significant losses.

3. Mark-to-market (MTM)

Futures contracts undergo a daily settlement process known as mark-to-market. Each day, the profits or losses from the new closing price of the futures contract are calculated and added to or deducted from the trader's margin account. This process ensures that losses are not allowed to accumulate, providing a mechanism for managing credit risk.

4. Clearing house guarantee

Every futures contract is backed by a clearing house associated with the exchange. The clearing house acts as the counterparty to both sides of the transaction, significantly reducing the credit risk for traders. This guarantee ensures that the contract will still be honoured even if one party defaults.

5. Hedging and speculation

One of the primary uses of futures contracts is for hedging, which involves taking a position in the futures market that is opposite to one's position in the physical market to reduce or limit the risk associated with price changes. Conversely, futures are also used for speculation, where traders attempt to profit from predicting price movements of the underlying asset.

6. Contract expiry

Each futures contract has a specific expiration date. As the expiry date approaches, traders must decide whether to settle their position (either by taking delivery of the underlying asset or by settling in cash, depending on the contract) or roll over their position to a new contract.

7. Liquidity

Futures contracts for widely traded commodities or financial instruments typically offer high liquidity, making it easier for traders to enter and exit positions. However, this might not be true for all futures contracts, especially those with less commonly traded underlying assets.

Applications of Forward and Futures Contracts

Forward contracts are vital in the world of finance, especially when they concern individuals who require a specific risk management solution. Such contracts allow companies to secure prices for commodities, currencies, or other assets they plan or intend to purchase or sell. This method is, therefore, mostly suitable for a rather exact budgeting and financial planning. In the international trade domain, businesses use forward contracts as a risk-hedging tool against currency exchange risk. Locking in exchange rates beforehand enables businesses to safeguard themselves from potential losses due to unfavourable currency fluctuations.

In addition to this, forward contracts are also a useful tool for producers as well as the consumers of the commodities, such as farmers or manufacturers. These contracts enable them to hedge the risk and get a fixed price guarantee. Hence, they effectively hedge the uncertainty of commodity prices. The major merit of the forward contracts is that these can be adjusted to the requirements, which does not happen with the futures contracts, which are standardised. This is in the sense of adjustment to particular quantities of or qualities of assets or even non-standard delivery dates, which makes them more versatile to meet the diverse needs of different clients.

On the other hand, futures contracts are widely used in market speculation. Such contracts are popular among traders who bet on the price trends of diversified assets, which range from commodities to stocks to currencies. The aim is normally to make a profit from the changes in these markets with the strategy of buying low and then selling at high prices or vice-versa. Like forward contracts, futures contracts can be used as tools for risk management. They are the best asset classes to hedge against price fluctuations in broadly based market exposures due to their liquidity and standardisation. Another meaningful characteristic that derivatives possess entails leveraged investments. The feature of these contracts, called margin trading, allows investors to realise huge contract values by staking only a small part of the resources or assets involved. This risk-reward ratio can enhance returns, but it also increases risk.

Now, let’s focus on another important aspect of this discussion – the risks associated with forwards and futures.

Risks Associated with Forward and Futures Contracts

Here is how you can better understand the different risks associated with forward and futures contracts: 

Risk Type	Forward Contracts	Futures Contracts
Counterparty Risk	High risk of default by the counterparty, as contracts are private.	Lower risk due to the involvement of a clearing house.
Market Risk	Subject to market risk, customisable contracts can mitigate this.	High, especially due to leverage, which can amplify losses.
Liquidity Risk	Lower liquidity due to the customised nature and lack of a secondary market.	Generally high liquidity, but varies based on the asset and contract terms.
Regulatory Risk	Lesser regulation, which can lead to enforcement issues.	Highly regulated, offering more legal structure and oversight.
Credit Risk	Higher, as the performance is reliant on the counterparty's ability to fulfil the contract.	Reduced credit risk due to standardised procedures and the clearing house's guarantee.
Operational Risk	Risk associated with a contract's customisation can lead to disputes.	Standardised contracts reduce operational risks.
Settlement Risk	Risk of settlement failure due to the contract's non-standardized nature.	Standardised settlement processes reduce this risk.
Basis Risk	Can be minimised through customisation to match specific needs.	Basis risk (the risk that the futures price won't move in line with the underlying asset) can be a concern, especially for hedgers.

 

As the chapter comes to an end, it is apparent that the difference between Futures and Forward Contracts is a key knowledge for anybody willing to take on the world of currency derivatives. They can both be very effective tools to protect against market uncertainties, but they have individual risks and operational particularities. With a better understanding of these differences, the financial market becomes less complicated, and we can direct our strategies according to our risk appetite and investment plans. With this information, you are now more prepared to explore the dynamic derivatives trading environment.