Forward and futures contracts are derivatives that involve two parties who agree to buy or sell a specific asset at a set price by a certain date in the future. Buyers and sellers can mitigate the risks of price changes by locking them in advance.
A forward is made over the counter (OTC) and settles just once—at the end of the contract. Both parties involved in the agreement privately negotiate the contract's exact terms. Forwards carry a default risk since the other party might not come up with the goods or the payment.
Futures contracts, meanwhile, are standardized to trade on stock exchanges. As such, they are settled daily. These arrangements come with fixed maturity dates and uniform terms. They have far less counterparty, as they guarantee payment on the agreed-upon date.
Key Takeaways
- Forward and futures contracts involve two parties agreeing to buy and sell an asset at a specified price by a specific date.
- A forward contract is a private, customizable agreement that settles at the end of the agreement and is traded over the counter (OTC).
- A futures contract has standardized terms and is traded on an exchange, where prices are settled daily until the end of the contract.
- There is less oversight for forward contracts as privately negotiated, while futures are regulated by the Commodity Futures Trading Commission (CFTC).
- Forwards have more counterparty risk than futures.
Forward Contracts
Forward contracts are privately negotiated agreements between a buyer and a seller to trade an asset at a future date at a given price. They don’t trade on an exchange and have more flexible terms and conditions, including the amount of the underlying asset and how it will be delivered. Forwards have one settlement date: the end of the contract.
Many hedgers use forward contracts to reduce the potential volatility of an asset’s price. Since the terms are set when they are executed, forward contracts don't fluctuate in price. That means if two parties agree to the sale of 1,000 ears of corn at $1 each (for a total of $1,000), then the terms cannot change even if the price of corn goes down to 50 cents an ear.
Forwards are not readily available to retail investors, and the market for them is often hard to predict. That’s because the agreements and their details are generally kept between the buyer and the seller, and are not made public. Since they are private agreements, there is a higher degree of counterparty risk, which means there may be a chance that one party will default.
While forward contracts settle just once, futures contracts can settle over a range of dates.
Futures Contracts
Like forwards, futures contracts involve agreeing to buy and sell an asset at a specific price at a future date. These contracts are marked to market daily, which means that daily changes are settled daily until the end of the contract. The futures market is generally highly liquid, giving investors the ability to enter and exit whenever they choose to do so.
These contracts are frequently used by speculators looking to profit from an asset's price moves. Speculators typically close their contracts before maturity and delivery usually never happens. In this case, a cash settlement usually takes place.
Because they are traded on an exchange, exchanges partner with clearinghouses that act as the counterparty when you go to buy futures through your broker. This drastically lowers the chances of default. As of 2024, the most traded futures were in equities (65% by volume), currencies (9%), interest rates (9%), energy (5%), agriculture (4%), and metals (4%).
Key Differences Between Futures and Forwards
Futures are overseen in the U.S. by the Commodity Futures Trading Commission (CFTC), the Financial Industry Regulatory Authority, nongovernmental Futures Industry Association, individual exchanges, clearinghouses, and brokers. The CFTC was established in 1974 to regulate the derivatives market, to ensure the markets run efficiently, and to protect investors from fraud and consumers from market manipulation.
It's often been said that forwards are largely unregulated since they are one-on-one contracts. That was never quite right since myriad federal, state, and local laws attach to both contracts and specific underlying assets. But that's clearly no longer the case. Changes after the 2007-8 financial crisis and new regulations in the past decade have brought greater transparency to the OTC market. Nevertheless, forward contracts come with fewer safeguards. Meanwhile, futures are backed by clearinghouses. Unlike forwards, where there is no guarantee until the contract is settled, futures require a deposit or margin. This acts as collateral to cover the risk of default.
The underlying assets associated with forward and futures contracts include financial assets (stocks, bonds, currencies, market indexes, and interest rates) and commodities (crops, precious metals, and oil- and gas-related products).
Forward Contracts vs. Futures Contracts Example
To see how these types of derivatives work, let’s look at two examples for comparison.
Forward Contracts
Suppose a producer has an abundant supply of soybeans and is concerned that the commodity’s price will drop soon. To hedge the risk, the producer negotiates with a financial institution to sell three million bushels of soybeans for $6.50 per bushel in six months. Both parties agree to settle the contract in cash.
The outcome of this contract for soybeans can vary in these ways:
- The future price is exactly as contracted. The contract is settled per the agreement, and neither party owes the other any money.
- The price is lower than the negotiated price. Let’s say the price drops to $5 per bushel, but the settlement still goes through at the agreed-upon price. This means that the producer’s bet to hedge the risk of a price drop works.
- The price is higher than the agreed-upon price. The contract is settled at the negotiated price, even though the producer may have profited from a higher cost per bushel.
Futures Contracts
Oil producers often use futures to lock in a price and then proceed with delivery once the expiration date hits. Suppose Company A is afraid that demand will slow, affecting the price of oil on the market, which in turn will impact the company's bottom line. The company enters into a futures contract to lock in the oil price at $75 a barrel, believing it will drop in six months.
If demand drops and the price sinks to $65 per barrel, Company A can still settle the contract at the original contract price of $75 per barrel, making a profit of $10 per barrel. However, should the price of oil go to $85 a barrel, Company A will lose out on the $10-per-barrel profit, though it was still protected from the financial crisis it might face should oil go down by a lot.
Forwards vs. Futures
Forwards
Trade OTC
Customizable terms
Often no upfront cost
Higher counterparty risk
Futures
Trade on listed exchanges
Standardized terms
Contracts must be paid for with an initial margin
Very low counterparty risk
What Is Margin in Futures Contracts and How Is It Different For Forward?
Margin in futures contracts refers to the initial deposit required to enter into a contract, as well as the maintenance margin needed to keep the position open. This system of margining helps manage the risk of default by ensuring that participants have enough funds to cover potential losses. By contrast, forward contracts do not typically require margin, as they are private agreements with the risk managed through checking the creditworthiness of the parties involved.
When Would A Trader Prefer a Forward to a Futures Contract and Vice Versa?
A trader or investor might prefer a forward contract when they require a customized agreement to hedge specific risks or when dealing with commodities or assets that are not standardized. Forwards are also worthwhile for parties seeking privacy. Conversely, a futures contract might be preferred for its liquidity, ease of access, and regulatory oversight, making it suitable for speculation or hedging in more standardized and transparent markets.
What Are the Main Disadvantages of a Forward Contract?
There are several key disadvantages of a forward contract. For instance, their details are not made public, as they are negotiated privately between the two parties involved and because they trade over the counter. They offer more flexibility but also have higher counterparty risk. The regulatory environment can significantly impact the choice between forwards and futures, depending on the trader's or investor's risk tolerance and compliance requirements if trading for a firm.
The Bottom Line
Forward contracts are made privately between two parties over the counter and settlement dates and what's exchanged at maturity are set, not marked to market. Since the forward contract is negotiated between two counterparties, there is the risk that one of them may default and not fulfill the agreement's terms, known as counterparty risk. On the other hand, a futures contract is a fixed contract traded on a futures exchange, like the New York Mercantile Exchange, which has margin requirements that back up the futures contract, essentially eliminating counterparty risk. Futures contracts are also traded when the exchange is open and can be marked to market in real-time
What futures and forwards have in common is the ability to lock in a set price, amount, and expiration date for the exchange of the underlying asset.
