Difference Between Forward and Future Contracts Explained

Profits are essential but protecting against potential losses and managing risk is just as important. In other words, some trades are made to protect against decline in another asset’s value. Forward contracts and future contracts are types of derivative contracts that can be used for both speculation as well hedging. Both look similar, but there are several key differences between them.

In this blog, we will understand step by step what forward and future contracts are, what is the difference between futures and forwards, when which contract is better and important things related to them which every trader and investor should know.

What is a Forward Contract?

A forward contract is an agreement in which two parties agree to buy or sell an asset (such as a stock, commodity or currency) at a fixed price and on a fixed date in the future. These contracts are over-the-counter (OTC), that is, they are not traded on an exchange but privately between two parties. The terms of the contracts can be customized: quantity, price, delivery date, everything is decided by both the parties by mutual consent. But due to this, the counterparty risk is high, i.e. the other party may default on its obligations.

In the stock market and commodity market, forward contracts are mostly used by large institutional investors, exporters or importers, who want to avoid future price risk.

Example: Suppose a farmer and a trader decide that 1 ton of wheat will be sold after 3 months at the rate of ₹2,000 per quintal. Even if the market price at that time is ₹1,800 or ₹2,200, the deal will be done at the same fixed price.

Key points:

• Fully customizable
• OTC transactions
• Higher risk (counterparty default)

What is a Future Contract?

A futures contract is a derivative agreement in which two parties agree to buy or sell an asset (such as a stock, commodity or currency) at a fixed price at a future date but these contracts are traded on an exchange, which makes them standardized and regulated. Each futures contract represents a specific quantity, expiry date, and strike price. They are traded on an exchange (such as NSE or MCX), and require parties to deposit margins— an upfront amount that both parties have to pay to reduce the risk of default.

The trading positions of both the parties are marked to market daily, i.e. every day the profit or loss is calculated and adjusted in the account. This is why futures contracts are popular among traders for speculation as they can be easily sold on an exchange.

Example: Suppose a trader buys Nifty Futures for June expiry at a price of ₹25,000. If Nifty’s spot price increases to ₹25,500, then the trader can easily sell the futures contract and realise a profit.

Key points:

• Standardized contracts traded on exchanges
• Low counterparty risk
• Daily settlement and margin required to reduce counterparty risk 

Read Also: What is Future Trading and How Does It Work?

Similarities Between Forward and Future Contracts

Some of the similarities between the forward contracts and futures contract are mentioned below:

• Both are derivative instruments: Their value depends on an underlying asset such as stocks, commodities or currency.
• Delivery or settlement on a future date: Both contracts are an agreement to buy or sell an asset at a fixed price and date in the future.
• Used for risk management and hedging: They are either used to take advantage of future price fluctuations, i.e. speculate or used to hedge against adverse price fluctuations.

Key Differences Between Forward and Future Contracts

Parameters	Forward Contract	Future Contract
Trading Platform	Over-the-counter (OTC), privately traded	Traded on an exchange (like NSE,BSE, MCX)
Standardization	Fully customized, terms are set by parties involved	Completely standardized with predefined specifications
Margin requirement	Usually isn’t required	Margin needs to be deposited
Settlement Method	Settlement happens only on maturity	Mark-to-market settlement takes place daily
Liquidity	Less liquid as traded OTC	More liquid, as traded on an exchange
Default risk	The risk of counterparty default is high	Risk is very low due to clearing house mechanism
Price Transparency	Less transparent	Complete transparency as it is traded
Regulation	No under direct supervision of any regulatory body	Regulated
Flexibility	The terms are completely customizable depending upon the parties	Fixed contract size, expiry and strike price
Users	Mostly institutional investors, exporters/importers	Traders, investors, hedge funds and arbitrageurs

When to Use Forwards vs Futures?

When to use a Forward Contract?

• When a specific deal is required and full customization of contract terms is necessary.
• For long-term agreements, such as when an exporter/importer wants to fix transaction prices in the future.
• When an OTC (Over The Counter) private agreement is more convenient and the counterparty is trustworthy.

When to use a Future Contract?

• When high liquidity, transparency and a regulated trading environment are required.
• For short-term trading or speculation, such as taking advantage of daily price movements in indices or commodities.
• When the risk of counterparty default needs to be avoided and exchange-backed settlement is preferred.

If flexibility and customization is required then a Forward Contract is better. But if safety, liquidity and transparency are required then a Future Contract is a better option.

Read Also: Top 10 Trading Apps in India

Advantages and Disadvantages of Forward and Futures Contracts

Every contract has its own strengths and limitations. Let’s see what are the advantages and disadvantages of forward and future contracts:

Advantages of Forward Contract

• Flexible terms: Buyer and seller can decide the quantity, price and maturity by mutual consent.
• Customization: Tailor-made deals are possible according to specific requirements.

Disadvantages of Forward Contract

• Counterparty Risk: Being OTC, the risk of default is high.
• Low Liquidity: It is difficult to trade in the secondary market.

Advantages of Future Contract

• Transparent Pricing: Price is publicly available on the exchange.
• High Liquidity & Safety: Being standardized, they can be easily traded and clearinghouse guarantees settlement.

Disadvantages of Future Contract

• Limited Flexibility: Terms are predefined, due to which customization is not possible.
• Risk of Margin Call: Due to daily price movement, you may be required to deposit extra margin.

Conclusion

Both forward and futures contracts are used to manage price risk. Forward contracts are more flexible and customised, while futures contracts offer higher liquidity and transparency. Forwards are more suitable for long-term deals, while futures are a better option for speculating. Choosing the right option depends on your financial objectives and risk appetite.

Frequently Asked Questions