Forward contracts and futures contracts are two financial instruments used in trading. Both are derivatives contracts that allow two parties to agree on the price of an underlying asset at a future date. Despite their similarities, they have some significant differences that traders must be aware of. In this article, we will look at a comparison between forward contracts and futures contracts.
Definition
A forward contract is an agreement between two parties to buy or sell an underlying asset at a future date for a price agreed today. The contract`s terms are negotiated between the two parties, and the transaction takes place at the contract`s maturity date. A futures contract is a standardized derivative contract traded on an exchange that obligates both parties to buy or sell an underlying asset at a future date for a set price.
Trading
Forward contracts are over-the-counter (OTC) instruments, which means they are not traded on exchanges. They are privately negotiated between two parties, and the terms and conditions are not standardized. Futures contracts, on the other hand, are traded on organized exchanges, making them more accessible to traders. The standardized nature of futures contracts results in reduced transaction costs for traders.
Price determination
The price of a forward contract is determined by the parties involved and is based on the current market price of the underlying asset, as well as other factors such as time to maturity and interest rates. Futures contracts, however, have a specified price that is determined by the market, which is based on supply and demand. This makes futures contracts more transparent and easily accessible to traders.
Size of contract
Forward contracts are customizable, which means the contract size can be tailored to the underlying asset`s specific size. The contract size can be as small or as large as the parties involved agree upon. Futures contracts, however, have predetermined contract sizes that are fixed by the exchange. This means that traders must trade designated contract sizes, which may be too big or too small for their needs.
Delivery and settlement
Forward contracts have a specific delivery date, which means that the buyer must take delivery of the underlying asset on that date. Settlement of a forward contract can be physical or cash settled, depending on the agreement between the two parties. Futures contracts, however, are settled daily, which means that each day`s gains or losses are settled at the end of the trading day. Futures contracts are typically cash-settled, which means there is no actual delivery of the underlying asset.
Conclusion
Forward contracts and futures contracts are both useful financial instruments. Forward contracts are customizable, privately negotiated agreements between two parties, while futures contracts are standardized exchange-traded contracts. The choice between the two depends on the trader`s needs, preferences, and trading strategy. Understanding the differences between forward contracts and futures contracts is critical for traders to make informed decisions.