Forward and Future Contract Difference

Forward and future contracts are two types of financial instruments that investors can use to manage their risk exposure in the market. Although they are both derivatives, there are several differences between the two that investors must understand before choosing which one to use.

A forward contract is an agreement between two parties to buy or sell an asset at a predetermined price and date in the future. The contract is typically customized to meet the needs of both parties, and there is no centralized exchange where it is traded. Instead, the parties negotiate terms directly with each other.

In contrast, a futures contract is a standardized agreement to buy or sell an asset at a specified price and date in the future. The contract is traded on a centralized exchange, and all the terms and conditions are standardized. This makes futures more accessible and easier to trade than forwards.

One of the key differences between forwards and futures is the way they are settled. A forward contract is settled at the end of the contract period, while a futures contract is settled daily. This means that the gains or losses from a futures contract are settled at the end of each trading day, whereas the gains or losses from a forward contract are settled only at the end of the contract period.

Another difference between the two is the margin requirement. In a futures contract, both parties are required to deposit a margin, which serves as collateral for their positions. This margin is typically a small percentage of the total contract value, and it can be adjusted daily based on the market movements. In a forward contract, no margin is required, and the parties are relying solely on the creditworthiness of each other.

Lastly, the liquidity of the two instruments differs. Futures contracts are more liquid than forwards, and they can be traded anytime during the trading hours on the exchange. This makes it easier for investors to enter and exit their positions quickly. Forward contracts, on the other hand, are less liquid and can be more challenging to unwind before the contract`s maturity.

In conclusion, both forward and futures contracts can be used by investors to manage their risk exposure in the market. However, they differ in settlement methods, margin requirements, and liquidity. Understanding these differences can help investors choose the right instrument when investing in the market.