Forward and futures are both financial contracts that allow investors to buy or sell an underlying asset at a predetermined price at a specific date. Both of these contracts are used to hedge against market volatility and to lock in the prices of commodities, currencies, stocks, and bonds. However, there are some fundamental differences between the two that investors need to keep in mind.
Definition
A futures contract is a standardized agreement between two parties to buy or sell an underlying asset at a future date and a fixed price. These contracts are traded on exchanges like the Chicago Mercantile Exchange (CME) and the New York Mercantile Exchange (NYMEX). In contrast, a forward contract is an over-the-counter (OTC) agreement between two parties to buy or sell an underlying asset at a future date and a mutually agreed price.
Trading
Futures contracts can be traded on exchanges, meaning that they are standardized and can be bought or sold by any registered member of the exchange. They are also highly regulated and standardized, which means that they are transparent, liquid, and less risky. On the other hand, forward contracts are traded over-the-counter (OTC), meaning that they are customized and not standardized. They are also less regulated, less transparent, and less liquid compared to futures contracts.
Pricing
The pricing of futures contracts is determined by the market forces of supply and demand, which means that the price is constantly changing depending on the market conditions. In contrast, the pricing of forward contracts is based on the current market conditions and interest rates, which means that the price is fixed at the time the agreement is made.
Delivery
Futures contracts are settled on the expiration date, meaning that the underlying asset must be delivered or taken delivery of on that date. In contrast, forward contracts can be settled at any time agreed upon by the parties to the contract.
Risk
Futures contracts are considered to be less risky than forward contracts because they are traded on exchanges, which means that they are standardized and highly regulated. On the other hand, forward contracts are customized and less regulated, which means that they are more susceptible to counterparty risk.
Conclusion
In conclusion, forward and futures contracts are similar in that they both allow investors to lock in prices for a future date. However, they differ in terms of where they are traded, how they are priced, when they are settled, and the level of risk involved. Investors must understand these differences before deciding which contract to use for hedging their investments against market volatility.