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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.
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.
Trade Procedure
In a forward contract, the buyer and seller are private parties who negotiate a contract that obligates them to trade an underlying asset at a specific price on a certain date in the future. Since it is a private contract, it is not traded on an exchange but over the counter. No cash or assets change hands until the maturity date of the contract. There is usually a clear "winner" and "loser" in forward contracts, as one party will profit at the point of contract maturity, while the other party will take a loss. For example, if the market price of the underlying asset is higher than the price agreed in the forward contract, the seller loses. The contract may be fulfilled either via delivery of the underlying asset or a cash settlement for an amount equal to the difference between the market price and the price set in the contract i.e., the difference between the forward rate specified in the contract and the market rate on the date of maturity. For an intro to forward contracts, watch this video from Khan Academy.
Whereas a forward contract is a customized contract drawn up between two parties, a futures contract is a standardized version of a forward contract that is sold on a securities exchange. The terms that are standardized include price, date, quantity, trading procedures, and place of delivery (or terms for cash settlements). Only futures for assets standardized and listed on the exchange can be traded. For example, a farmer with a corn crop might want to lock in a good market price to sell his harvest, and a company that makes popcorn might want to lock in a good market price to buy corn. On the futures exchange, there are standard contracts for such situations — say, a standard contract with the terms of "1,000 kg of corn for $0.30/kg for delivery on 10/31/2015." here are even futures based on the performance of certain stock indices, like the S&P 500. For an intro to futures, watch the following video, also from Khan Academy:
Investors trade futures on the exchange through brokerage firms, like E*TRADE, that have a seat on the exchange. These brokerage firms take responsibility for fulfilling contracts.
Closing a Position
To close a position on a futures trade, a buyer or seller makes a second transaction that takes the opposite position of their original transaction. In other words, a seller switches to buying to close his position, and a buyer switches to selling. For a forward contract, there are two ways to close a position — either sell the contract to a third party, or get into a new forward contract with the opposite trade.
Standardizing a contract and trading it on an exchange provides some valuable benefits to futures contracts, as discussed below.
Risk
Forward contracts are subject to counterparty risk, which is the risk that the party on the other side of the trade defaults on their contractual obligation. For example, AIG's insolvency during the 2008 crisis subjected many other financial institutions to counterparty risk because they had contracts (called credit default swaps) with AIG.
The futures exchange's clearinghouse guarantees transactions, thereby eliminating counterparty risk in futures contracts. Of course, there is the risk that the clearinghouse itself will default, but the mechanics of trading are such that this risk is very low. Futures traders are required to deposit money — usually 10% to 20% of the contract value — in a margin account with the brokerage firm that represents them on the exchange to cover their exposure. The clearinghouse takes positions on both sides of a futures trade; futures are marked to market every day, with the brokers making sure there are enough assets in margin accounts for traders to cover their positions.
Margin Calls
Futures and forwards also carry market risk, which varies depending on the underlying asset it. Investors in futures, however, are more vulnerable to volatility in the price of the underlying asset. Because futures are marked to market daily, investors are liable for losses incurred daily. If the asset price fluctuates so much that the money in an investor's margin account falls below the minimum margin requirement, their broker issues a margin call. This requires the investor to either deposit more money in the margin account as collateral against further losses, or be forced to close their position at a loss. If the underlying asset swings in the opposite direction after the investor is forced to close their position, they lose out on a potential gain.
With forward contracts, no cash is exchanged until the maturity date. So in that scenario, the holder of a forward contract would still end up ahead.
Prices
The price of a futures contract resets to zero at the end of every day because daily profits and losses (based on the prices of the underlying asset) are exchanged by traders via their margin accounts. In contrast, a forward contract starts to become less or more valuable over time until the maturity date, the only time when either contracting party profits or loses.
So on any given trading day, the price of a futures contract will be different from a forward contract that has the same maturity date and strike price. The following video explains price divergence between futures and forward contracts:
Liquidity and Price Transparency
It is easy to buy and sell futures on the exchange. It is harder to find a counterparty over-the-counter to trade in forward contracts that are non-standard. The volume of transactions on an exchange is higher than OTC derivatives, so futures contracts tend to be more liquid.
Futures exchanges also provide price transparency; prices for forward contracts are only known to the trading parties.
Regulation
Futures are regulated by a central regulatory authority like the CFTC in the United States. On the other hand, forwards are governed by the applicable contract law.
Volumes
The majority of futures trading takes place in North America and Asia and deals with individual equities.
References
- Futures Contract Definition and Example - Investing Answers
- a futures price differs from a forward price - Bionic Turtle on YouTube
- are futures? - MoneyWeek Investment Tutorials on YouTube
- Wikipedia: Forward contract
- Wikipedia: Futures contract
- Forward and Futures Contracts - MIT Finance Theory on YouTube
