Introduction
Very often we say things we don’t mean. ‘Sure, I’ll wash the dishes tonight’ or ‘Yes, that movie is the best thing you will see’ or ‘Oh my! That is the best dessert I have ever tasted’ or the biggest lie of all (mostly) – ‘I will get up at six tomorrow morning’. All of us have indulged ourselves in these lies occasionally. They are, most times, harmless. What is the worse that could happen if these lies were unaccomplished? A stinky sink full of dirty vessels, a headache from trying to make sense of a senseless movie, an upset stomach from the half-baked pie and more sleep time. The last one is not as bad. It is more of a guilty pleasure at the cost of the missed chores.
In the popular TV series – Game of Thrones, adapted from the book series, ‘A Song of Ice and Fire’ by George R. R. Martin, one of the main characters, Jon Snow, says, “When enough people make false promises, words stop meaning anything”. It stresses the importance of meaning what you say. Words uttered have worth but if uttered with no intention of following through, they stop being valuable. Promises are such words that carry value. A promise is solemn and binding. Every word of a promise bears weight and if broken, could at the very least lead to a break of trust. A promise is much like an agreement between people, where one person declares they will or won’t do something.
Futures Contract vs. Forward Contract
Like promises, contracts also are agreements. These are legally binding and are enforced by the law. Two such contracts that often confuse are futures contracts and forward contracts. While they sound similar, they are rather different. The main difference between them is that futures contracts are publicly traded, while forward contracts are privately traded. There are other differences between the two.
Differences Between Futures Contracts and Forward Contracts in a Tabular Form
| Parameters of Comparison | Futures Contracts | Forward Contracts |
| Definition | A futures contract is an agreement between parties to exchange an asset for cash at a fixed price on a specified date in the future. | A forward contract is an agreement between parties to either buy or sell an asset at an agreed-upon rate on a specified date in the future. |
| Structure | A futures contract is a standardized contract. | A forward contract is a custom-made contract that is tailored to the customer’s needs. |
| Traded on | A futures contract takes place in an organized stock exchange. | A forward contract takes place over the counter i.e. there is no secondary market involved. |
| Purpose | A futures contract is often used for speculation. Here, an initial payment is required. | A forward contract is mostly used for hedging. Initial payment is not required. |
| Settlement | A futures contract is settled daily. | A forward contract is settled on the maturity date. |
| Risk | There is a low risk in a futures contract. | There is a high risk in a forward contract. |
| Default | There are no chances of default in a futures contract. | Since a forward contract is a private agreement, the chances of default are relatively high. |
| Size of contract | The size of a futures contract is fixed. | The size of a forward contract depends on the terms of the contract. |
| Collateral | A futures contract requires collateral. | A forward contract does not require an initial payment. |
| Contract maturity | A futures contract may not mature by the delivery of the commodity. | A forward contract generally matures by delivering the commodity. |
| Regulation | A futures contract is regulated by the government or an exchange committee. | A forward contract is self-regulated. |
| Liquidity | The liquidity is high in a futures contract. | The liquidity is low in a forward contract. |
What are Futures Contracts?
A futures contract, also known as futures, is a binding contract that is executed at a specific date in the future. A futures contract is a standardized contract. The contract is standardized in terms of the quantity, the date and time. It is an exchange contract between parties where the underlying asset is traded for cash at a fixed rate on a fixed date. An asset in such a scenario is either a financial asset like stocks, bonds etc. or a commodity like gold. In this contract, the buyer holds the long position and the seller holds the short position.
In a futures contract, the assets are publicly traded. They are traded in an official exchange. This exchange functions as the mediator and the facilitator between the buyer and the seller. It also makes certain that the parties pay a marginal upfront cost that serves as collateral.
Unlike a forward contract, which is self-regulated, a futures contract is regulated by the exchange. Thus, they come with a lower risk. Since the futures contract is marked to the market, there are fluctuations in the prices of the commodities which is why the prices are settled daily. This causes the investors to be liable for losses or gains daily.
A futures contract is divided into two categories:
Commodity Futures
In this futures contract, the asset is a commodity like gold, coffee, aluminium etc.
Financial Futures
In this futures contract, the asset is a financial instrument like currency or a treasury bill.
To close a position in a futures contract, the buyer or the seller must take the opposite of the original position. For example, a buyer in a futures contract must close the transaction by becoming the seller and vice versa.
An example of a futures contract is as follows:
A futures contract is used often by oil producers to sell oil. Say an oil-producing company X is afraid that the oil demand is going to drop in the future, so it enters into a futures contract locking the price of every barrel at ‘y’.
If the demand does drop and the price reduces to ‘y-5’, company X can still settle the contract on the original price of ‘y’ per barrel and gain a profit. But if demand rises and the price of each barrel rises to ‘y+5’, company X stands to lose an additional 5 units per barrel profit from the contract.
What are Forward Contracts?
It is an agreement between parties to either buy or sell an underlying asset at a fixed point in the future for a specified price. It is a private agreement and since it is private, it is not traded on an exchange. The trade takes place over the counter. The cash or assets do not change hands until the date of maturity is reached. Thus, in the end, there is a winner or a loser i.e. one party profits, while the other experiences a loss. For example, if the market price of an asset is lower than the agreed-upon price in the forward contract, the seller makes a profit.
Also, since it is a private agreement, the contract is more flexible in terms of deciding the nature of or units of the assets and the dates of delivery etc. It is customized to the needs of the parties. The contract is settled at the end of the agreement – on the settlement date. The settlement date, time, quality, rate etc. are predetermined by the parties involved. A forward contract can be closed on a settlement date by delivering the underlying asset or a cash settlement. A forward contract bears a higher risk since no authority provides oversight to the agreement and it takes place privately.
Many hedgers use forward contracts to reduce the risk of the contract. As the terms of the contract are fixed before the start of the venture, the price of the asset seldom sees a fluctuation. Because of the nature of this agreement, forward contracts are not easily available to retail investors (non-professional investors who trade through traditional or online brokerage firms). The market values are harder to predict for them since the forward contract is kept private between the buyer and the seller.
Forward contracts are not marked-to-market like futures contracts. They are settled on the negotiated date. Forward contracts are also not regulated by an exchange. They are self-regulated. Guarantees are also different for futures and forward contracts. There is no guarantee in a forward contract till the settlement date is reached.
An example of the forward contract in action is as follows:
Say a producer of coffee beans is afraid that the price of coffee will drop in the future. To hedge the risk, they enter into a forward contract with a financial institution that negotiated the contract of sale of a million bags of coffee at a price of ‘x’ per bag in six months. Both parties agree to settle the agreement in cash at the end of the contract.
The price of the coffee beans can fluctuate in the following ways:
- The price remains as contracted. The contract is settled without either of the party having to pay any excess amount.
- The price drops. The value of the coffee beans reduces to ‘x-5’. The settlement goes through at the agreed-upon price. This confirms the fears of the producer.
The price now becomes higher than the negotiated price. Nevertheless, the contract is settled at the negotiated price and the producer gains the profits.
Main Differences Between Futures Contract and Forward Contract In Points
Following are the main differences between futures contracts and forwards contracts:
- A futures contract is an agreement between parties to exchange an asset for cash at a fixed price on a fixed date. A forward contract, on the other hand, is an agreement between parties to either buy or sell an underlying asset on a specified date in the future at an agreed-upon rate.
- A futures contract requires an initial payment and is usually used for speculation. A forward contract is usually used for hedging and does not require an initial payment or collateral.
- A futures contract is a standardized contract, while the forward contract is customized to the needs of the customer.
- A futures contract bears low risk, whereas a forward contract bears a high risk.
- The trade of a futures contract takes place in a stock exchange. In a forward contract, the trade takes place over the counter with no secondary market involved.
- A futures contract is settled daily, while a forward contract is settled on the maturity date.
- The size of a futures contract is fixed, while the size of a forward contract is dependent on the terms of the contract.
- A futures contract is regulated by the government or an exchange board, whereas a forward contract is self-regulated.
- In a forward contract, the contract reaches maturity at the end, after the delivery of the commodity which may not happen with a futures contract.
- The liquidity is high in a futures contract, while it is low in a forward contract.
Conclusion
The futures and forward contracts are thus agreements between parties. A futures contract is a contract between parties that exchange an asset for a fixed price on a fixed date. It is a standardized contract that has a relatively low risk. The trade of a futures contract takes place via an exchange board. The prices of the commodities fluctuate depending on the market. The futures contract is regulated by the exchange committee.
A forward contract, on the other hand, is self-regulated. It is a private agreement between parties. It involves the buying or selling of an asset at a fixed rate on a fixed date and there is no exchange of assets. The assets are traded privately, over the counter i.e. there is no secondary market. The settlement date concludes the arrangement. Since it is a private agreement, it bears a higher risk. Both of these agreements are contracts that strive to deliver the terms of the contract by the end. Surely, the prices see an up and down but to honour the contract remains important. Much like promises.
