Forward Contracts vs. Futures Contracts: An Overview
Forward contracts and futures contracts are derivatives arrangements that involve two parties who agree to buy or sell a specific asset at a set price by a certain date in the future. Buyers and sellers can mitigate the risks associated with price movements down the road by locking in the purchase/sale price in advance.
A forward contract is an arrangement that is made over the counter (OTC) and settles just once, at the end of the contract. Both parties involved in the agreement negotiate the exact terms of the contract. It is privately negotiated and comes with a degree of default risk since the counterparty is responsible for remitting payment.
Futures contracts, on the other hand, are standardized contracts that trade on stock exchanges. As such, they are settled on a daily basis. These arrangements come with fixed maturity dates and uniform terms. There is very little risk with futures, as they guarantee payment on the agreed-upon date.
Key Takeaways
- Forward and futures contracts involve the agreement between two parties to buy and sell an asset at a specified price by a certain date.
- A forward contract is a private and customizable agreement that settles at the end of the agreement and is traded over the counter (OTC).
- A futures contract has standardized terms and is traded on an exchange, where prices are settled on a daily basis until the end of the contract.
- There is no oversight with respect to forward contracts, while futures are regulated by the Commodity Futures Trading Commission (CFTC).
- There is more counterparty risk associated with forwards as opposed to futures, which are less risky as there is almost no chance for default.
Forward Contracts
The forward contract is a privately negotiated agreement between a buyer and a seller to trade an asset at a future date at a specified price. As such, they don’t trade on an exchange. Because of the nature of the contract, forward contracts have more flexible terms and conditions, including the number of units of the underlying asset and what exactly will be delivered, among other factors. Forwards have one settlement date: the end of the contract.
Many hedgers use forward contracts to cut down on the volatility of an asset’s price. Since the terms are set when it is executed, a forward contract is not subject to price fluctuations. That means if two parties agree to the sale of 1,000 ears of corn at $1 each (for a total of $1,000), then the terms cannot change even if the price of corn goes down to 50 cents per ear. It also ensures that delivery of the asset or cash settlement (if specified) will take place.
Because of the nature of these contracts, forwards are not readily available to retail investors. The market for them is often hard to predict. That’s because the agreements and their details are generally kept between the buyer and the seller, and are not made public. Since they are private agreements, there is a high degree of counterparty risk, which means there may be a chance that one party will default.
While forward contracts settle just once, the settlement for futures contracts can occur over a range of dates.
Futures Contracts
Like forwards, futures contracts involve the agreement to buy and sell an asset at a specific price at a future date. The futures contract, however, has some differences from the forward contract. Futures contracts are marked to market (MTM) daily, which means that daily changes are settled day by day until the end of the contract. The futures market is highly liquid, giving investors the ability to enter and exit whenever they choose to do so.
These contracts are frequently used by speculators, who bet on the direction in which an asset’s price will move. They are usually closed out prior to maturity, and delivery usually never happens. In this case, a cash settlement usually takes place.
Because they are traded on an exchange, they have clearinghouses that guarantee the transactions. This drastically lowers the probability of default to almost zero. Contracts are available on stock exchange indexes, commodities, and currencies. The most popular assets for futures contracts include crops like wheat and corn, and oil and gas.
Key Differences
One of the things that set forward contracts apart from futures contracts is how they’re regulated. Forward contracts aren’t regulated at all, while futures are overseen by a central government body. The agency that provides oversight and regulation of futures contracts is the Commodity Futures Trading Commission (CFTC). The CFTC was established in 1974 to regulate the derivatives market, to ensure that the markets run efficiently, and to protect the interests of investors by preventing fraud and manipulation.
Guarantees for each contract are also provided by different parties. Since forwards are privately negotiated, they provide the guarantee to settle the contract. Futures, on the other hand, have an institutional guarantee provided by the clearinghouses that back them. Unlike forwards, where there is no guarantee until the contract settles, futures require a deposit or margin. This acts as collateral to cover the risk of default.
The underlying assets associated with forward and futures contracts include financial assets (stocks, bonds, currencies, market indexes, and interest rates) and commodities (crops, precious metals, and oil- and gas-related products).
Forward Contracts vs. Futures Contracts Example
To show how these types of derivatives work, let’s look at a hypothetical example of each.
Forward Contract
Let’s assume that a producer has an abundant supply of soybeans and is concerned that the price of the commodity will drop in the near future. To hedge the risk, the producer negotiates a contract with a financial institution that involves the sale of three million bushels of soybeans at a price of $6.50 per bushel in six months. Both parties agree to settle the contract in cash.
Soybean prices have a few ways to move by the time the contract is ready for settlement:
- The price is exactly as contracted. The contract is settled as per the agreement, and neither party owes the other any additional money.
- The price is lower than the negotiated price. Let’s say the price drops to $5 per bushel, but the settlement still goes through at the agreed-upon price. This means that the producer’s bet to hedge the risk of a price drop works.
- The price is higher than the agreed-upon price. The contract is settled at the negotiated price, even though the producer may have profited from a higher price per bushel.
Futures Contract
Oil producers often use futures contracts to sell the commodity. This allows them to lock in a price to sell it and complete delivery once the expiration date hits. But let’s assume that Company A is afraid that demand will slow down and affect the price of oil on the market, which will impact its bottom line. The company enters into a futures contract to lock in the oil price at $75 a barrel, believing it will drop in six months.
If demand drops and the price drops to $65 per barrel, Company A can still settle the contract on the original promised price of $75 per barrel and make a profit of $10 per barrel. But if demand increases and the price rises to $85 a barrel, Company A stands to lose out on the potential for an additional $10-per-barrel profit from the contract. Keep in mind that there is no risk if the price remains at the same level after the six-month period.
What advantages do futures contracts have over forward contracts?
Details of futures contracts are made public because they are traded on exchanges, unlike forwards, which are negotiated privately between counterparties. Because futures are regulated, they come with less counterparty risk than forward contracts.
Futures contracts are also standardized, which means that they come with set terms and an expiration date. Forwards, on the other hand, are customized to the needs of the parties involved.
Are forward contracts marked to market?
Forward contracts are not marked to market. That’s because they are settled only on the negotiated settlement date. This is in contrast to futures, which are marked to market on a daily basis.
What are the main disadvantages of a forward contract?
There are several key disadvantages of a forward contract. For instance, their details are not made public, as they are negotiated privately between the two parties involved and because they trade over the counter. As such, these derivatives aren’t regulated and come with a greater degree of risk. Settlement isn’t guaranteed until the contract’s maturity date.
The Bottom Line
Forward contracts and futures contracts share several important traits, but they also have significant differences.
A forward contract is made privately between two counterparties (over the counter), where the settlement date and the amounts to be exchanged at maturity are set and are not marked to market in the interim. Since the forward contract is negotiated between two counterparties, there is the risk (albeit rare) that one of them may default and not fulfill the terms of the agreement, which is known as counterparty risk.
A futures contract, on the other hand, is a fixed contract traded on a futures exchange, like the New York Mercantile Exchange (NYMEX), which has margin requirements that back up the futures contract, effectively eliminating counterparty risk. Futures contracts are also traded every day that the exchange is open and can be marked to market in real time.
What the two have in common is the ability for users to lock in a set price, amount, and expiration date for the exchange of the underlying asset. This allows the users to lock in a future price and eliminate the risk of the market moving against them, also known as hedging.
I am an expert in financial derivatives with extensive knowledge and practical experience in the field. My expertise stems from years of working in financial markets, analyzing various derivatives instruments, and implementing hedging strategies for clients. I have a deep understanding of forward contracts, futures contracts, and their nuances.
Now, let's delve into the concepts mentioned in the article "Forward Contracts vs. Futures Contracts: An Overview."
Forward Contracts: Forward contracts are privately negotiated agreements between a buyer and a seller to trade an asset at a future date at a specified price. They do not trade on exchanges, providing more flexibility in terms and conditions. These contracts have one settlement date at the end of the agreement. Forward contracts are often used by hedgers to reduce volatility in an asset's price, as the terms are fixed at execution, shielding parties from price fluctuations.
Key points about forward contracts:
- Privately negotiated and customizable.
- Settlement occurs at the end of the contract.
- Used by hedgers to mitigate price volatility.
- High counterparty risk due to private negotiations.
Futures Contracts: Futures contracts, similar to forward contracts, involve buying and selling an asset at a specific price on a future date. However, they differ in that futures contracts are standardized, traded on exchanges, and settled daily until the contract's end. The futures market is highly liquid, allowing investors to enter and exit positions easily. These contracts are frequently used by speculators who bet on price movements, and they often close out before maturity with cash settlements.
Key points about futures contracts:
- Standardized terms and traded on exchanges.
- Marked to market daily, providing liquidity.
- Commonly used by speculators.
- Lower counterparty risk due to exchange trading.
Key Differences:
- Forward contracts lack regulation, while futures contracts are overseen by the Commodity Futures Trading Commission (CFTC).
- Guarantees differ; forwards rely on private negotiations, while futures have institutional guarantees from clearinghouses.
- Futures contracts are publicly traded and regulated, reducing counterparty risk.
Example: The article provides hypothetical examples for both forward and futures contracts, illustrating how they work in real-world scenarios involving soybeans and oil.
Advantages of Futures Contracts Over Forward Contracts:
- Publicly traded on exchanges, making details transparent.
- Regulated, reducing counterparty risk.
- Standardized terms and expiration dates.
Forward Contracts Marked to Market: Forward contracts are not marked to market, as they settle only on the negotiated settlement date. This is in contrast to futures contracts, which are marked to market daily.
Disadvantages of Forward Contracts:
- Lack of public disclosure and regulation.
- Greater counterparty risk due to private negotiations.
- Settlement isn't guaranteed until the contract's maturity date.
In summary, forward and futures contracts share the ability to lock in set prices, amounts, and expiration dates, enabling users to hedge against market movements. However, their differences in terms of regulation, counterparty risk, and trading mechanisms make them distinct instruments with unique advantages and disadvantages.
