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Forward Contracts vs. Futures Contracts: What's the Difference?

Both forward and futures contracts are derivative instruments whose values can be derived from financial products such as equity stocks, interest rate bonds, currencies, and commodities, as well as non-financial products such as weather conditions, carbon emissions, pollution levels, etc.



Here are some differences between the two:

  • Meaning: forward contracts are agreements entered into by two parties (buyer and seller) to trade an asset at some future date at an agreed price/rate while futures contracts are agreements entered by a party (buyer or seller) with an Exchange with standardized terms.

  • Trading: forward contracts are traded over the counter (negotiated) between two parties while futures contracts are traded on the Exchange platform where one party is the buyer/seller and the other is the exchange.

  • Standardization: forward contracts are non-standardized contracts where the terms such as forward price/rate, lot size, maturity date, asset quality, etc. are agreed upon between both parties while futures contracts are highly standardized.

  • Settlement: forward contracts are settled on the maturity date, the date agreed upon by both parties in the contract, usually with physical delivery while future contracts are settled on a daily basis, and that too mark-to-market cash.

  • Margin/Collateral Requirements: theoretically, forward contracts have no requirement to post collateral at any point while futures contracts require a margin at initial, some maintenance margin, and a variation margin.

  • Regulation: theoretically, forward contracts are not regulated by any authority/exchange (self-regulated) while futures contracts are regulated by the exchange commission.

  • Credit Risk: forward contracts are exposed to counterparty risk as the other party may default on his obligations while futures contracts have almost zero counterparty risk as there is no possibility of default due to daily the mark-to-market feature.

  • Liquidity Risk: forward contracts are less liquid as a forward contract can only be terminated between the agreed parties while futures contracts can easily be liquidated on the exchange platform and hence involve less liquidity risk.

  • Best Use: forward contracts are recommended best for hedging financial risk as they are highly customizable while futures contracts are appropriate for speculation as they have almost zero counterparty risk with ease to exit from the contract.


 

Impact of Interest Rates on Futures and Forwards

The impact of interest rate change depends on the position held in the contract, whether long or short, and whether the change in interest rate is favorable or unfavorable to the position.

Forwards:

  • If interest rates decrease, the holder of a long position (i.e., the buyer) in a forward contract may benefit as the cost of borrowing to finance the purchase of the underlying asset may be lower.

  • If interest rates increase, the holder of a short position (i.e., the seller) in a forward contract may benefit as the income earned from lending the proceeds from the sale of the underlying asset may be higher.

Futures:

  • If interest rates decrease, the party with a negative mark-to-market value will benefit as they will be able to finance the margin requirement at a lower cost.

  • If interest rates increase, the party with a positive mark-to-market will benefit as they will earn more on the funds held in the margin or paid out.

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