The fundamental difference between futures and forwards is that futures are traded on exchanges and forwards trade OTC. The difference in trading venues gives rise to notable differences in the two instruments:
- Futures are standardized instruments transacted through brokerage firms that hold a "seat" on the exchange that trades that particular contract. The terms of a futures contract - including delivery places and dates, volume, technical specifications, and trading and credit procedures - are standardized for each type of contract. Like an ordinary stock trade, two parties will work through their respective brokers, to transact a futures trade. An investor can only trade in the futures contracts that are supported by each exchange. In contrast, forwards are entirely customized and all the terms of the contract are privately negotiated between parties. They can be keyed to almost any conceivable underlying asset or measure. The settlement date, notional amount of the contract and settlement form (cash or physical) are entirely up to the parties to the contract.
- Forwards entail both market risk and credit risk. Those who engage in futures transactions assume exposure to default by the exchange's clearing house. For OTC derivatives, the exposure is to default by the counterparty who may fail to perform on a forward. The profit or loss on a forward contract is only realized at the time of settlement, so the credit exposure can keep increasing.
- With futures, credit risk mitigation measures, such as regular mark-to-market and margining, are automatically required. The exchanges employ a system whereby counterparties exchange daily payments of profits or losses on the days they occur. Through these margin payments, a futures contract's market value is effectively reset to zero at the end of each trading day. This all but eliminates credit risk.
- The daily cash flows associated with margining can skew futures prices, causing them to diverge from corresponding forward prices.
- Futures are settled at the settlement price fixed on the last trading date of the contract (i.e. at the end). Forwards are settled at the forward price agreed on at the trade date (i.e. at the start).
- Futures are generally subject to a single regulatory regime in one jurisdiction, while forwards - although usually transacted by regulated firms - are transacted across jurisdictional boundaries and are primarily governed by the contractual relations between the parties.
- In case of physical delivery, the forward contract specifies to whom the delivery should be made. The counterparty on a futures contract is chosen randomly by the exchange.
- In a forward there are no cash flows until delivery, whereas in futures there are margin requirements and periodic margin calls.
TradingBoth forward and futures contracts allow investors to buy or sell an asset at a specific time and price.
InvestingA forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date.
TradingThis article expands on the complex structure of derivatives by explaining how an investor can assess interest rate parity and implement covered interest arbitrage by using a currency forward ...
TradingFutures and derivatives get a bad rap after the 2008 financial crisis, but these instruments are meant to mitigate market risk.
TradingWe explain what forex futures are, where they are traded, and the tools you need to successfully trade these derivatives.
MarketsFutures is short for Futures Contracts, which are contracts between a buyer and seller of an asset who agree to exchange goods and money at a future date, but at a price and quantity determined ...
InvestingOptions on futures contracts offer another way for day traders to use options. These are traded on the same exchange as the underlying futures contract. Traders should take care to understand ...
MarketsDiscover the differences between oil futures market prices and oil spot market prices and what leads to the differences between the two.
TradingWe look at the top eight advantages of trading futures over stocks.
TradingCurrency risk can be effectively hedged by locking in an exchange rate through the use of currency futures, forwards, options, or exchange-traded funds.