A derivative instrument is a contract whose value depends upon the price of underlying commodity, security or index. There are several kinds of derivative instruments like forward contracts, futures contracts, options, and swap agreements. All these helps in shifting the price risk associated with the holding and trading these kinds of assets.
Futures and forward are financial contracts between parties to buy and sell a commodity at some point in the future for a predetermined price. These contracts are used to trade securities, currencies and commodities, where the contracts are set to be settled at a future date. Although a Futures Contract is similar to a Forward Contract in that both are agreements to trade on a set future date, there are some significant differences.
A futures contract is a standardized contract traded on an official exchange (futures market), to buy or sell a certain underlying instrument at a certain date in the future, at a specified price.
In other words, It is a contract between a buyer and seller which gives the buyer the obligation to accept delivery and the seller is obligated to provide delivery of a fixed amount of a commodity at a fixed price and at a specified location, which is specifically stated within the agreement. Both parties of a “futures contract” must have to fulfill the contract on the settlement date. Futures contracts are traded exclusively on regulated commodities exchanges and are settled daily based on their current value in the marketplace. Their terms remains the same; the only thing that changes is the price, which is determined usually through an auction system, called open-outcry trading, conducted on the floor of the exchange.
A non-standardized transaction to buy or sell a specific financial instrument or asset at some period in the future at a specified price.
Forward contract is traded over the counter and all details of the contract are negotiated between the counterparties, or partners to the agreement. The price specified in the forward contract for foreign currency, government securities, or other commodities may be higher or lower than the actual market price at the time of delivery. But the participants have locked in a price early so they know what they will receive or pay for the product, eliminating market risk. Forward contracts are subject to the credit risk factors of the counterparty, or the person with whom the transaction is done, which is eliminated in the futures market because the clearinghouse guarantees payment.
Point Of Difference Between Futures Contract and Forward Contract
- Futures are always traded on an exchange, whereas forwards always trade over-the-counter (OTC), or can simply be a signed contract between two parties
- Futures contracts are exchange-traded and, therefore, are highly standardized contracts whereas Forward contracts are private agreements and are not as rigid in their stated terms and conditions.
- Futures contracts have clearing houses that guarantee the transactions, which drastically lowers the probability of default whereas in Forward contracts there are chances of defaults as there is regulated committee in-between.
- Futures contracts are marked-to-market daily, which means that gains/losses settled daily until the end of the contract whereas in Forward contracts, settlement of the contract occurs at the end of the contract.
- Settlement for futures contracts can occur over a range of dates whereas Forward contracts only possess one settlement date.
- Futures contract are mostly used by speculators and usually closed out prior to maturity and physical commodity transfer usually never happens whereas Forward contracts are mostly used by hedgers that want to eliminate the volatility of an asset’s price, and delivery of the asset or cash settlement will usually take place.
- if at anytime a participant in a futures contract wishes to transfer his obligation to another party, he can do so by selling it to another willing party in the futures market whereas there is essentially no secondary market for forward contracts.
- In Futures contract both parties must deposit an initial deposit (margin) required whereas Forward contracts are customized to customers needs and usually no initial payment required.