Forward contracts vs futures contracts - Learn about the key differences

Financial derivatives such as forwards and futures enable investors to hedge risk or earn potential returns by betting on the prices of underlying assets such as commodities, currencies, bonds and stocks. Forwards and futures are two types of derivatives.

Although forward and futures contracts sound alike in many respects, there are certain differences between the two instruments that investors need to know. Continue reading to find out more.

• Table of contents

1. Futures contract definition
2. Forward contract definition
3. Examples of forward contracts and futures contracts
4. Futures vs forwards: Key differences

Futures contract definition

A futures contract is a standardised agreement traded on an exchange to buy or sell an underlying asset at a specified price on a future date. The key features of futures contracts are below.

• Standardised contract terms: Futures contracts have standardised terms like contract size, expiry dates and tick size set by the exchange to allow efficient trading.
• Trade on exchanges: Futures trade on regulated exchanges, making price movements transparent and easy to monitor.
• Marked-to-market daily: Gains and losses are settled daily based on the futures price movements.
• Low counterparty risk: The exchange clearinghouse acts as the counterparty to all trades, mitigating default risk.
• Leverage: Futures only require a small margin deposit, allowing investors to gain greater exposure with less upfront capital.
• Regulations: Futures trading is regulated by exchanges and financial regulators.

Some examples of popular futures contracts include stock futures, gold futures, crude oil futures, index futures and USD/INR currency futures. Companies and institutional investors commonly use futures to hedge commodity price risk or speculate on market directions.

Forward contract definition

A forward contract is a private agreement between two parties to buy or sell an asset at a specified price on a future date. Forwards represent an over-the-counter (OTC) contract between two counterparties. The key features of forward contracts are below.

• Customised terms: Forwards have customisable contract terms like size and settlement date agreed between the two counterparties.
• Over-the-counter: Forwards trade over-the-counter through private negotiation rather than on an exchange.
• Settled at maturity: Gains and losses are realised when the contract expires on the settlement date.
• High counterparty risk: Default risk is borne by the counterparties involved.
• Less regulation: Forwards are less regulated compared to futures.
• Low leverage: Forwards often require the full contract value as margin.

Some common examples of forward contracts include foreign exchange forwards used by importers/exporters to hedge currency risk and commodity forwards used by producers/consumers to lock in input/output prices.

Examples of forward contracts and futures contracts

Let's look at some examples to understand how forward and futures contracts are used in practice.

• Gold futures contract: An investor buys 1 kg gold futures contract on MCX at Rs. 50,000 expiring in 1 month to speculate on rising gold prices. This gives the investor exposure to 1 kg physical gold without needing to pay the full value upfront. The contract is marked-to-market daily and gains and losses are settled based on gold price changes.
• Currency forward: An exporter enters into a 3-month USD/INR forward contract to sell $1 million at Rs. 80 per USD with a bank to hedge his foreign currency risk. This locks in an exchange rate helping protect against currency fluctuations.
• Commodity forward: A cotton farmer agrees to sell 20 quintals of cotton to a textile company in 6 months at Rs. 5,000 per quintal through a forward contract to hedge against price declines.
• Index futures: A fund manager buys Sensex futures contracts worth Rs. 5 crore to gain exposure to the equity market index performance with leverage. Gains and losses are settled daily based on index level changes.

Futures vs forwards: Key differences

While both futures and forwards contracts involve an agreement to buy or sell and asset at a future date, there are some important differences:

• Standardisation: Futures have standardised contract terms set by the exchange while forwards are customisable bilateral contracts.
• Trading: Futures trade on exchanges providing greater liquidity while forwards trade over the counter.
• Counterparty risk: Futures have minimal counterparty risk due to exchange clearinghouse while forwards have significant bilateral default risk.
• Margin requirements: Futures require a small initial margin while forwards often require the full value locked upfront.
• Daily settlement: Futures are marked-to-market daily while forwards are settled only at maturity.
• Regulation: Futures are strictly regulated by exchanges while forwards have less regulation.
• Participants: Futures are used by institutional and retail investors while forwards are commonly used by producers, consumers and speculators.

Conclusion

While forward and futures contracts are similar derivatives used for hedging, speculation and leveraging exposures, futures offer standardisation, liquidity and minimal counterparty risk as exchange-traded instruments. Forwards provide customised bilateral contracts for producers and consumers but with higher counterparty risk. Understanding these key differences allows investors to decide whether futures or forwards better match their investment needs and risk management preferences.

Also Read: Can mutual funds invest in futures and options? A detailed guide

FAQs:

What is a forward contract?

A forward contract is a tailor-made over-the-counter derivative agreement among two parties to purchase or sell an underlying instrument at an agreed price on a future date. Forwards are bilateral contracts with conditions such as the contract size and settlement date agreed between the counter parties.

What is a futures contract?

A futures contract is a standardised derivative agreement to purchase or sell an underlying asset on a futures exchange at a predetermined price on a future date. Futures have standardised terms such as contract size, expiry and tick size determined by the exchange for convenient trading. They are widely used for speculating, hedging and taking leveraged exposure by institutional investors.

How do forward contracts and futures contracts differ?

The key differences are that futures are exchange-traded and standardised but forwards are over-the-counter bilateral contracts that are customisable. Futures carry very little counterparty risk because of the exchange clearinghouse whereas forwards carry high bilateral counterparty risk. Futures are marked-to-market on a daily basis, but forwards are settled only at maturity. Futures are highly regulated by exchanges, but forwards are less so.

What are the main features of forward contracts?

The key characteristics of forward contracts are term customisation such as contract size and settlement date, over-the-counter trading by private agreement, settlement upon maturity instead of on a daily basis, high counterparty default risk, and lower regulation than that of futures contracts.

What are the main features of futures contracts?

The key characteristics of futures contracts are standardisation of terms, trading on regulated exchanges to ensure liquidity, low counterparty risk from exchange-based clearinghouse, mark-to-market settlement of gains/losses every day, high leverage with small margin requirements, and strict controls by exchanges and regulators.

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