forward contract vs future contract

Futures Contract Vs Forward Contract

The main difference between futures and forward contracts is that futures are standardized and traded on exchanges, offering more liquidity and less credit risk. Forwards are private agreements, customizable and traded over-the-counter which lead to higher counterparty risk but more flexibility.

Futures Contract Meaning

A futures contract is a standardized legal agreement to buy or sell an asset at a predetermined price at a specified future date. Traded on exchanges, it’s used for hedging or speculation, offering high liquidity and involving a commitment to transact in financial instruments or physical commodities.

A futures contract is a financial instrument where parties agree to trade a specific asset, like commodities or stocks, at a set price and date. It’s standardized in terms of quantity and quality, ensuring consistency across all contracts.

Traded on organized exchanges, futures provide high liquidity and are often used for hedging risks or speculative investments. They require a margin deposit as security, mitigating credit risk. The futures market is regulated, adding a layer of security for participants.

For Example: Consider an investor who anticipates that the shares of Company XYZ, currently trading at ₹100, will rise. They buy a futures contract for 100 shares at ₹100 (₹10,000 total). If the stock rises to ₹120, the contract is now worth ₹12,000, and the investor profits ₹2,000. If the stock falls to ₹80, however, they face a ₹2,000 loss.

What Is A Forward Contract?

A forward contract is a customized agreement between two parties to buy or sell an asset at a specified future date for a price agreed upon today. Traded over-the-counter and not on exchanges, it’s used for hedging and tailored to the parties’ specific needs and terms.

A forward contract involves a private deal directly between two entities to trade an asset at a future date, at a pre-agreed price. It’s not standardized and is created based on the parties’ specific requirements.

These contracts are traded over-the-counter (OTC), not on formal exchanges. This allows for customization but increases counterparty risk, as there’s no centralized clearinghouse. They’re typically used by businesses to hedge against price fluctuations in commodities or currencies.

For Example: Consider an investor who signs a forward contract to purchase 500 shares at ₹200 each in six months. If the market price rises to ₹250, they pay only ₹100,000 instead of ₹125,000, saving ₹25,000. Conversely, if the price drops, they incur a loss by paying above market value.

Forward Vs Future Contract

The main difference between futures and forward contracts is that futures are exchange-traded standardized agreements with higher liquidity and lower credit risk. In contrast, forwards are customizable, private contracts traded over the counter, offering flexibility but with increased counterparty risk.

Aspect

Futures Contracts

Forward Contracts

Trading Venue

Traded on formal exchanges.

Traded over-the-counter (OTC), not on exchanges.

Standardization

Standardized in terms of size and expiration.

Customizable to the needs of the parties involved.

Liquidity

Generally higher liquidity.

Less liquid compared to futures.

Credit Risk

Lower due to exchange regulation and margin requirements.

Higher as it depends on the counterparties’ creditworthiness.

Flexibility

Less flexible due to standardization.

More flexible, tailored to specific requirements.

Counterparty Risk

Mitigated by the exchange.

Higher, as there’s no central clearinghouse.

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