In the surface futures and forwards are both derivatives financial instruments. Despite it looks similar in nature, however, in term of technical details, futures and forward contracts are two very different financial products. The differences are not just in the way they function and trade but also serve completely different purposes from a trader’s perspective. In order to truly understand how futures are different from forward contracts and to know why trading futures is better than the forward contracts, it is essential to have a good understanding on the subject of forward contracts first.
A forward contract is a customized contractual agreement where two private parties agree to trade a particular asset with each other at an agreed specific price and time in the future. Forward contracts are traded privately over-the-counter, not on an exchange.
A futures contract — often referred to as futures — is a standardized version of a forward contract that is publicly traded on a futures exchange. Like a forward contract, a futures contract includes an agreed upon price and time in the future to buy or sell an asset — usually stocks, bonds, or commodities, like gold.
In general, the main differentiating feature between futures and forward contracts — that futures are publicly traded on an exchange while forwards are privately traded — results in several operational differences between them. This comparison examines differences like counterparty risk, daily centralized clearing and mark-to-market, price transparency, and efficiency.
More the specific details of these contracts differences are as follows.
Firstly, futures contracts are exchange-traded and, therefore, are standardized contracts. Forward contracts, on the other hand, are private agreements between two parties and are not as rigid in their stated terms and conditions. Because forward contracts are private agreements, there is a high counterparty risk i.e. a chance that a party may default on its side of the agreement. Futures contracts have clearing houses that guarantee the transactions, which drastically lowers the probability of default to almost never.
Secondly, the specific details concerning settlement and delivery are quite distinct. For forward contracts, settlement of the contract occurs at the end of the contract. Futures contracts are marked-to-market daily, which means that daily changes are settled day by day until the end of the contract. Furthermore, the settlement for futures contracts can occur over a range of dates. Forward contracts, on the other hand, only possess one settlement date.
Thirdly, because futures contracts are quite frequently employed 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. On the other hand, 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.
Fourth, forwards contracts have credit risk, but futures do not because a clearing house guarantees against default risk by taking both sides of the trade and marking to market their positions every night. Mark to market is the process of converting daily gains and losses into actual cash gains and losses each night. As one party loses on the trade the other party gains, and the clearing house moves the payments for the counterparty through this process.
Lastly, forward contracts are basically unregulated, while future contracts are regulated at the federal government level. The regulation is there to ensure that no manipulation occurs, that trades are reported in a timely manner and that the professionals in the market are qualified and honest.