When it comes to trading in derivatives, two commonly used instruments are futures contracts and forward contracts. While both of them are similar in nature, there are some significant differences that traders need to be aware of. In this article, we will break down the differences between futures contracts and forward contracts in tabular form.

Factors Futures Contracts Forward Contracts

Definition A futures contract is a standardised agreement between two parties to buy or sell a certain asset on a specific future date at a pre-determined price. A forward contract is a bespoke agreement between two parties to buy or sell a certain asset on a specific future date at a pre-determined price.

Standardisation Futures contracts are standardised in terms of contract size, expiration date, and delivery location. Forward contracts are customised according to the needs of the contracting parties.

Trading Futures contracts are traded on an exchange, and the exchange acts as the counterparty for every trade. Forward contracts are traded over-the-counter (OTC), and there is no centralised exchange to facilitate the trade.

Counterparty Risk The exchange acts as the counterparty for all futures contracts, and the risk of default is minimal. There is a higher risk of counterparty default in forward contracts as they are traded OTC.

Mark-to-market Futures contracts are marked-to-market daily, which means that the profits and losses are settled every day. Forward contracts are not marked-to-market, and profits and losses are realised only on the settlement date.

Liquidity Futures contracts are highly liquid, and traders can enter and exit positions easily. Forward contracts may have lower liquidity, and traders may find it difficult to find a counterparty to exit their positions.

Flexibility Futures contracts have limited flexibility as they are standardised. Forward contracts offer greater flexibility as they can be customised to suit the needs of the contracting parties.

Margin Futures contracts require margin to be deposited by both parties as a form of collateral. Forward contracts do not require margin as they are traded directly between the contracting parties.

Settlement Futures contracts are settled on the expiration date, and the delivery of the underlying asset is mandatory. Forward contracts are settled on the settlement date, and the delivery of the underlying asset can be optional.

In conclusion, futures contracts and forward contracts serve the same purpose of enabling traders to hedge against price fluctuations in the underlying asset. While futures contracts are standardised and traded on an exchange, forward contracts are customised and traded over-the-counter. Both instruments have their advantages and disadvantages, and traders need to carefully evaluate their needs and risk appetite before choosing which one to trade.