Forward vs Futures
Functions performed by both futures and forwards contracts are similar to each other, in that they allow the user of the contract to either buy or sell a specific asset at an agreed upon price during a specific time period. Even though their functions are quite similar their characteristics and the purpose for which each of them are used are different. The following article provides a clear outline of each type of security and outlines their differences.
What is Futures Contract?
Futures contracts are standardized contracts that list out a specific asset to be exchanged on a specific date or time at a specified price. The standardized nature of futures contracts allows them to be exchange traded on a financial exchange called the ‘futures exchange market’.
Futures contracts operate through clearing houses that guarantee the transaction will take place, and therefore, ensures that the buyer of the contract will not default. Settlement of a futures contract occurs daily, where the changes in price are settled on a daily basis until the contract expires (called marked-to-market).
Futures contracts are usually used for speculation purposes, where a speculator bets on the movement of the price of the asset, and make profit depending on the accuracy of their judgment.
What is Forward Contract?
Forward contracts personalized agreements between two private parties, which therefore, make their terms and conditions much relaxed. However, since a forward contract is private and depends on the honesty and integrity of either party, there is a possibility for default on the agreement. Settlement of a forward contract occurs at the end of the contract period where the seller will sell the asset at the specified date (called the settlement date) for the agreed upon price.
Forward contracts are usually used for hedging. Hedging is an action taken by a forward contract buyer who wishes to offset and potential losses that may be made in an investment. For example, if the buyer of the forward contract assumes the price of the asset to rise to $10 in the future, he may buy a contract that allows him to purchase the asset at $8. If, by chance, the price of the asset falls to $6 in the future he is making a loss since he will be purchasing it at $6.
What is the difference between Forward and Futures?
The major difference between the two contracts is that futures contracts are rigid but secured, whereas forward contracts are flexible but risky. Both forward contracts and futures contracts are similar to each other in that they are both used to hedge risk and accomplish the common goal of risk management.
Summary of Futures vs Forward Contracts
• Functions performed by both futures and forwards contracts are similar to each other, in that they allow the user of the contract to either buy or sell a specific asset at an agreed upon price during a specific time period.
• Futures contracts are standardized contracts that list out a specific asset to be exchanged on a specific date or time at a specified price.
• Forward contracts personalized agreements between two private parties, which therefore, make their terms and conditions much relaxed.
• Both forward contracts and futures contracts are similar to each other in that they are both used to hedge risk and accomplish the common goal of risk management.