Forward and futures contracts are both important financial instruments used for trading commodities, foreign currencies, stocks, and other assets. Although these two agreements may seem similar, they have some fundamental differences that investors must understand before deciding which one to choose for specific transactions.
In this article, we will discuss the differences between forward and futures contracts with examples.
Forward Contracts:
In a forward contract, two parties enter into a private agreement to exchange an asset at a future date, at a pre-determined price. There is no centralized platform for forward contracts, which means they are traded between two parties without any intermediary. Therefore, the terms and conditions of the agreement are highly customizable, and the settlement takes place at the expiration date.
For example, let`s say that John wants to buy 100 barrels of crude oil from XYZ Oil Company at $60 a barrel after three months. Both John and XYZ Oil Company sign a forward contract for 100 barrels of crude oil at $60 per barrel to be delivered in three months. John is obligated to buy the crude oil at that price, and XYZ Oil Company is obligated to sell the crude oil at that price.
Futures Contracts:
Futures contracts are similar to forward contracts in that they both involve an agreement to buy or sell an asset at a certain price and future date. However, futures contracts are traded on exchanges, meaning there is a centralized platform for trading, and they are standardized, meaning there are fewer possibilities for customization.
Futures contracts typically require margin deposits to ensure that both parties fulfill their obligations when the contract expires. Additionally, futures contracts are settled daily, meaning gains and losses are credited or debited to the account each day and, therefore, require more frequent monitoring.
For example, let`s say that John wants to buy 100 barrels of crude oil from XYZ Oil Company in three months, but instead of signing a forward contract, they choose to trade a futures contract. John buys one futures contract for 100 barrels of crude oil at $60 per barrel for delivery in three months, and XYZ Oil Company sells one futures contract for 100 barrels of crude oil at $60 per barrel for delivery in three months. If the price of crude oil rises to $70 per barrel in three months, John will make a profit of $1000 (100 barrels x ($70-$60)).
Key differences between Forward and Futures Contracts:
1. Standardization: Futures contracts are standardized, so there are fewer possibilities for customization, while forward contracts are highly customizable, meaning the terms and conditions can be tailored to suit the needs of the parties.
2. Trading Venue: Futures contracts are traded on exchanges, which means there is a centralized platform for trading , while forward contracts are traded between two parties without any intermediary.
3. Margin: Futures contracts require margin deposits, while forward contracts do not.
4. Settlement: Futures contracts are settled daily, while forward contracts are settled on the expiration date.
Conclusion:
In conclusion, both forward and futures contracts are critical financial instruments that enable traders and investors to hedge risks and make profits by speculating on the future prices of assets. While they share some similarities, they differ in terms of standardization, trading venue, margin requirements, and settlement. Therefore, it is essential to understand the differences between these two contracts before using them in any financial transaction.