Derivatives - Futures vs. Forwards
Futures differ from forwards in several instances:
- A forward contract is a private transaction - a futures contract is not. Futures contracts are reported to the future's exchange, the clearing house and at least one regulatory agency. The price is recorded and available from pricing services.
- A future takes place on an organized exchange where the all of the contract's terms and conditions, except price, are formalized. Forwards are customized to meet the user's special needs. The future's standardization helps to create liquidity in the marketplace enabling participants to close out positions before expiration.
- Forwards have credit risk, but futures do not because a clearing house guarantees against default risk by taking both sides of the trade and marking to market their positions every night. Mark to market is the process of converting daily gains and losses into actual cash gains and losses each night. As one party loses on the trade the other party gains, and the clearing house moves the payments for the counterparty through this process.
- Forwards are basically unregulated, while future contract are regulated at the federal government level. The regulation is there to ensure that no manipulation occurs, that trades are reported in a timely manner and that the professionals in the market are qualified and honest.
Characteristics of Futures Contracts
In a futures contract there are two parties:
- The long position, or buyer, agrees to purchase the underlying at a later date or at the expiration date at a price that is agreed to at the beginning of the transaction. Buyers benefit from price increases.
- The short position, or seller, agrees to sell the underlying at a later date or at the expiration date at a price that is agreed to at the beginning of the transaction. Sellers benefit from price decreases.
Prices change daily in the marketplace and are marked to market on a daily basis.
At expiration, the buyer takes delivery of the underlying from the seller or the parties can agree to make a cash settlement.