Forward Contracts vs. Futures Contracts: An Overview
Both forward and futures contracts involve the agreement to buy and sell assets at a future date. A forward contract, though, settles at the end of the contract, while the settlement for a futures contract happens on a daily basis.
Both contracts fundamentally have the same function, however, the specific details of each are different.
- Both forward and futures contracts involve the agreement between two parties to buy and sell an asset at a specified price by a certain date.
- A forward contract is a private agreement that settles at the end of the agreement.
- A futures contract is traded on an exchange and is settled on a daily basis until the end of the contract.
- The forward contract is used primarily by hedgers who want to cut down the volatility of an asset's price, while futures are preferred by speculators who bet on where the price will move.
The forward contract is an agreement between a buyer and seller to trade an asset at a future date. The price of the asset is set when the contract is drawn up. Forward contracts have one settlement date—they all settle at the end of the contract.
These contracts are private agreements between two parties, so they do not trade on an exchange. Because of the nature of the contract, they are not as rigid in their terms and conditions.
Many hedgers use forward contracts to cut down on the volatility of an asset's price. Since the terms of the agreement are set when the contract is executed, a forward contract is not subject to price fluctuations. So if two parties agree to the sale of 1000 ears of corn at $1 each (for a total of $1,000), the terms cannot change even if the price of corn goes down to 50 cents per ear. It also ensures that delivery of the asset, or, if specified, cash settlement, will usually take place.
Because of the nature of these contracts, forwards are not readily available to retail investors. The market for forward contracts is often hard to predict. That's because the agreements and their details are generally kept between the buyer and seller, and are not made public. Because they are private agreements, there is a high counterparty risk. This means there may be a chance that one party will default.
Explaining Forward and Futures Contracts
Like forward contracts, futures contracts involve the agreement to buy and sell an asset at a specific price at a future date. The futures contract, however, has some differences from the forward contract.
First, futures contracts—also known as futures—are marked-to-market daily, which means that daily changes are settled day by day until the end of the contract. Furthermore, a settlement for futures contracts can occur over a range of dates.
Because they are traded on an exchange, they have clearing houses that guarantee the transactions. This drastically lowers the probability of default to almost never. Contracts are available on stock exchange indexes, commodities, and currencies. The most popular assets for futures contracts include crops like wheat and corn, and oil and gas.
The market for futures contracts is highly liquid, giving investors the ability to enter and exit whenever they choose to do so.
These contracts are frequently used by speculators, who bet on the direction in which an asset's price will move, they are usually closed out prior to maturity and delivery usually never happens. In this case, a cash settlement usually takes place.