4 Key Differences between Futures and Forward Contracts
Futures and forwards are both derivatives financial instruments and look similar in nature. However, when you look at the technical details, futures and forward contracts are two very different financial products, not just in the way they function and trade but also serve completely different purposes from a trader's perspective. To truly understand how futures are different from forward contracts and to know why trading futures is better than the forward contracts, it is essential to have a good understanding on the subject of forward contracts first.
What are forward contracts?
A forward contract is one of the simplest forms of derivatives where the contract value depends on the spot or market price of the underlying asset.
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A forward contract is an agreement between the buyer and a seller an asset or a commodity at a future date with the price of the asset, fixed at the time the contract is made. As the name suggests, the contract merely binds two parties to exchange the asset at a determined time in the future at a price that was agreed upon initially. The price at which the contract is fixed is referred to as the delivery price or the forward price.
Forward contracts are not standardized, meaning the terms of the quantity, quality of the asset and other factors are negotiated on a contract basis.
The party agreeing to buy the underlying asset in the forward contract is said to have taken a long position while the party agreeing to sell the underlying asset in the forward contract is said to have taken a short position.
Forward contracts are derivatives and can be used for hedging purposes primarily by producers.
Example of how a forward contract works
Joe is a farmer and his potato harvest is coming up soon. The price of potato has been fluctuating and Joe isn’t sure what the market price of potatoes will be once the produce is harvested and ready for the market. ACME Corp. makes potato chips and is always on the look out to clinch a good deal. Like Joe, ACME Corp. isn’t too fond of the volatility in potato prices as it eats into their profit margins.
Joe and ACME Corp. strike a deal. Both parties, Joe (the producer) and ACME Corp. (the consumer) agree to a forward contract.
The forward contract states that at the end of a specified date (90 days from the day the contract was signed), Joe would delivery 2 tonnes of Potatoes to ACME Corp. at a price of $5 per kilo.
For Joe, this seems an acceptable price as he can then budget the revenue from the potato harvest and for ACME Corp. the fixed price of $5 per kilo for 2 tonnes helps them to budget their production costs and have a better handle on pricing.
What happened here is that Joe and ACME Corp. just entered into a forward contract for potatoes, at a delivery price of $10,000 for a quantity of 2 tonnes to be delivered in 90 days.
Note that no money or asset changes hands at this point in time (the time when the contract is fixed).
90 days later, Joe is obliged to come up with 2 tonnes of potatoes, while ACME Corp. is obliged to come up with the money of $10,000 to pay Joe for his delivery. Regardless of what the current market price of potatoes is trading at because Joe and ACME Corp. entered into a forward contract, the transaction is sealed at $10,000 for 2 tonnes of potatoes.
In this example,
- potatoes are the underlying asset,
- the $5 per kilo is the delivery price or forward price also known as the cash settlement
- 2 tonnes of potatoes are the quantity that has been agreed upon also known as the physical delivery
Combined, this forms the forward contract for potatoes between Joe and ACME Corp. A forward contract can be for any asset or commodity, at any price (determined by the markets and on an agreement between both parties involved) and can be for any delivery period (weeks, months or years).
The main risk with a forward contract is when one of the participants fails to deliver. In the above example, Joe might fail to meet the agreed quota of 2 tonnes, or ACME Corp. might fail to come up with the required money. Problems can arise especially when price of the underlying asset remains volatile. An increase in the underlying price can be an incentive for Joe to default as he is likely to lose out, while a decline in prices will be an incentive for ACME Corp. which could have got a better deal.
While it might seem unthinkable to not honor a forward contract, there have been many well documented cases. Westinghouse Electric Corporation is one such entity which announced in September 1975 that it would not be honoring its fixed price contract to deliver 70 million pounds of Uranium, citing legal reasons.
Another important distinction with forward contracts is that it binding to two parties. Therefore, the contract must be fulfilled by the counter-party it was agreed with. Forward contracts are non-transferrable unless explicitly mentioned. In futures, traders can buy and sell contracts freely, even with third parties. This is one of the reasons why liquidity is so low in forward contracts. The picture below depicts this unique distinction between futures and forwards.
Types of Forward Contracts
Forward contracts are categorised into the following two types:
- Outright forward contracts
- Non-deliverable forwards contract or simply non-deliverable forwards (NDF’s)
As the name suggests, an outright forward contract is where there is a delivery of the asset (physical delivery) and exchange of cash (cash settlement).
A non-deliverable forwards contract or an NDF is where the counterparties to the forward contract agree to settle the difference at the prevailing spot price. NDF's are commonly used in the foreign exchange and commodity markets.
Going back to our example between Joe and ACME Corp. had the price of potatoes increased from $5 to $10 a kilo, and if the forward contract was struck as an NDF, then Joe being on the losing side of the transaction would simply prefer to settle the forward contract by paying ACME Corp. $10,000 and sell his potatoes elsewhere in hopes that price would increase further.
In the foreign exchange markets, a non-deliverable forward contract is where you can buy and sell a currency at a fixed future date for a predetermined rate. Forward rates are quoted as
- spot rate - premium
- spot rate + discount
The premium or discount is determined by the interest rates.
Premium or Discount for Forward Rates (in currency markets)
The NDF forward contracts represent the most common way to hedge currency volatility risks. Depending on the currency that you want to hedge, the forward rates can be as far out as 10 years (for currencies such as the US dollar, euro, British pound sterling or the Japanese yen).
Who benefits from forward contracts?
Forward contracts are ideally used for hedging purposes. Therefore, in the real world, forward contracts are used mostly by importers/exporters of goods or services where payments are paid in a foreign currency. Some financial businesses also engage in forward contracts that invest in foreign securities or make capital payments or involved in an acquisition of a foreign company. And as explained in the example, forward contracts can be used by merchants or producers of commodities who want to hedge the risks emanating from price volatility.
Even the average person can engage in a forward contract. For example if you want to do a money transfer, the most ideal way to do this is to engage in a forward contract so that the exchange rate is locked in.
4 Key Differences between Futures and Forward Contracts
|Futures Contracts||Forward Contracts|
|Counter party risk||No||Yes|
Exchange Traded: Futures contracts are exchange traded and are therefore very liquid. A trader or a speculator can trade the futures markets with large contract sizes without having to worry about finding buyers or sellers. An exchange traded futures contract also allows for price transparency thus offering all parties insight into the transactions that are taking place.
A forward contract on the other hand is privately negotiated between the buyer and seller. There is no price transparency outside of the two parties involved.
Regulated: Futures contracts trading is regulated by the Commodities and Futures Trading Commission, which ensures pre and post trade transparency and enforce other regulatory requirements on a exchange or a broker that wants to engage in the futures trading.
Forward contracts are traded over-the-counter, meaning that they are not regulated. This also opens up many more risks to the parties involved such as lack of liquidity or being unable to find the right buyer or seller at a price you are looking for.
Standardized: A standardized product in the futures contract offers consistency. For example, a Crude Oil futures contract implies the Light Sweet Crude Oil where each contract controls 1000 barrels of oil. This does not change, no matter how far out you buy the futures contract.
In forward contracts, the products are not standardized and depend between the two parties negotiating the contract. For example a buyer and seller can negotiate a forward contract for potatoes for a quantity of 2 tonnes, while someone else might negotiate another potatoes contract for 20 tonnes.
Counter-party risk: When you trade futures, the exchange takes on the counter-party risk. Furthermore, a performance bond or an initial margin is required to be put up by both the buyer and seller of the futures contract. Besides the initial margin, futures contracts are marked-to-market on a daily basis and depending on the price, both the buyer and the seller’s margin account is credited or debited. This ensures that there the risk of a default is minimal.
With a forward contract, there is a high level of counter-party risk. Although both parties agree to be bind by the terms of the forward contract, as illustrated earlier by the example of Westinghouse, there are means and ways to not honor a forward contract. At times there might be legitimate reasons behind not honoring a forward contract as well. Still, no matter what the reason may be, trading a forward contract always comes with a risk of a default.
Should you be trading futures or forwards?
By now the obvious answer should be futures contract. Besides the key points mentioned that differentiate futures from forwards, as a speculator, trading the liquidity rich futures markets offers you better chances as a speculator to take advantage of the price volatility. On the other hand, if volatility is exactly what you want to avoid, forward contracts are the way to go. But even then, there is always a winner and a lower to the contract, depending on the way you see it.
For the average retail trader, futures trading offer benefits that clearly outweigh trading forward contracts. From being able to trade for as little as $10,000 to trading in a regulated and a transparent environment trading futures contracts is more beneficial than trading forward contracts.