Definition
“Forwards” and “Futures” are both types of derivatives used for hedging risks or for speculation. A “Forward Contract” is a private agreement between two parties to buy or sell an asset at a certain price at a specified future date, and it’s not standardized. On the other hand, a “Futures Contract” is a legal agreement to buy or sell a particular commodity or asset at a predetermined price at a specified time in the future, is traded on an exchange and is standardized in terms of quality and quantity.
Key Takeaways
- Forwards are private agreements between two parties and therefore, are not standardized, giving them flexibility. Futures, on the other hand, are exchange-traded contracts hence they are standardized, offering lower counterparty risk and higher liquidity.
- Unlike futures contracts, forward contracts do not require an initial margin requirement, and therefore, possess a higher credit risk. In contrast, futures contracts demand a margin which significantly lowers the likelihood of a party defaulting on the contract.
- The settlement in futures contracts is marked-to-market, which means the gains or losses are settled on a daily basis, according to market movements. However, in forwards contracts, the settlement of profits or losses occurs only at the end of the contract.
Importance
The finance terms “Forwards” and “Futures” are both types of derivative contracts that allow two parties to buy or sell an asset at a specified price by a certain date. The distinction between them is important because of how they’re traded and their level of standardization.
Forward contracts are private agreements negotiated directly between two parties, typically used by businesses for hedging risks, and are customizable to the needs of both parties. However, this custom tailoring leads to a higher degree of risk, known as counterparty risk.
On the other hand, Futures contracts are standardized contracts and are traded on regulated exchanges, reducing the risk of default but allowing less flexibility. Knowing which contract to use depends on the risk tolerance, needs, and objectives of the parties involved, hence understanding these terms is crucial for any financial planning or decision-making process.
Explanation
Forwards contracts and futures contracts are integral tools utilized in the financial world to manage and hedge against risks associated with fluctuations in asset prices. A forward contract is a personalized agreement between two parties, typically used for hedging purposes in foreign exchange transactions or commodities trading to lock in a future price or rate. Since these contracts are private agreements, they can be tailored to fit unique requirements, such as the quantity and quality of the underlying asset, and the specific delivery date.
Banks, corporations, and fund managers often use forward contracts to hedge currency risk from overseas operations. On the other hand, futures contracts, also used for hedging and speculation, are standardized agreements traded on organized exchanges. These contracts mandate that the parties must buy or sell the asset at a specified price on a particular future date.
Futures contracts are commonly used in commodity trading, such as gold, oil, or agricultural products and are also utilised for trading in financial instruments like government bonds or equity indices. Moreover, since futures are traded on an exchange, they come with daily settlement – meaning, gains or losses on futures contracts are calculated and a trader’s margin account is adjusted on a daily basis. This eliminates the credit risk associated with forward contracts.
Hence, hedgers and speculators like day traders, brokers, and investors tend to use futures contracts for price discovery and risk mitigation.
Examples of Forwards vs Futures
Agriculture Industry: A farmer may enter into a Forward Contract with a buyer to sell a certain quantity of his harvest at a specified price at a future date. This way, the farmer can hedge against potential price fluctuations. On the other hand, in the Futures Market, standardized contracts for agricultural commodities (like wheat or corn) are traded on a futures exchange. These could be bought by food processing companies to protect against a rise in prices.
Currency Exchange: Businesses dealing in international trade may use Forwards to lock in an exchange rate for a future date to protect against potential currency fluctuation. Comparatively, currency futures are standardized contracts traded on an exchange where traders can speculate on the direction of a currency pair’s price.
Energy Sector: A power company could enter into a Forward Contract to buy coal at a specified price at a future point to manage their cost. Whereas, energy futures like crude oil futures or natural gas futures are traded on futures exchanges, allowing energy companies and investors to hedge against potential price changes.
FAQ: Forwards vs Futures
1. What are Forwards?
A forward contract is a private agreement between two parties to buy or sell an asset at a specified future date and price. Forwards are used for hedging risk or speculation. They are not standardized and are not usually traded on an exchange.
2. What are Futures?
Futures are derivative financial contracts obligating the buyer to purchase an asset, or the seller to sell an asset, at a predetermined future date and price. These are standardized and are traded on an exchange.
3. What are the differences between Forwards and Futures?
Futures contracts are exchange-traded, standardized contracts with legal backing. In contrast, forwards are private agreements between two parties and are not as rigid in their stated terms and conditions. The main difference lies in the fact that futures are standardized and traded on an exchange while forwards are bespoke, arranged between counterparties in the over-the-counter market.
4. What are the risks associated with Forwards and Futures?
Forwards are mainly exposed to default risk by the counterparty. This risk is minimized in futures due to the presence of a clearing house which guarantees each contract. However, futures are subject to daily changes in value, which means the parties must have a certain amount of capital to maintain the contract – known as the margin.
5. Can I cancel a Forwards or Futures contract?
Generally, forwards and futures contracts cannot be cancelled. However, they can be closed out by entering into a second contract. This process is more streamlined for futures because they are traded in an open market. Both forwards and futures might incur some loss or gain based on the market price at the time of closing.
Related Entrepreneurship Terms
- Contract size
- Delivery date
- Standardization
- Counterparty risk (credit risk)
- Exchange-traded (Futures) vs Over-the-Counter traded (Forwards)
Sources for More Information
- Investopedia: A comprehensive resource dedicated to investing and financial education that explains the difference between Forwards vs Futures.
- Corporate Finance Institute: They provide professional financial analyst training and it could give the user a deep insight into Forwards vs Futures.
- Economic Times: A comprehensive financial and commercial news website, providing news, opinion, data and analysis on the market, economy, and companies that may cover the topic of Forwards vs Futures.
- Financial Education: This website offers self-study courses in financial, mathematical, and business topics where the user can understand better about Forwards vs Futures.
