Differences between Forward Contracts & Future Contracts

Differences between Forward Contracts & Future Contracts

 The major differences between the forward contracts and futures contracted are as follows:

o   Nature and size of Contracts: Futures contracts are standardized contracts in that dealings in such contracts is permissible in standard-size sums, say multiples of 125,000 German Deutschmark or 12.5 million yen. Apart from standard-size contracts, maturities are also standardized. In contrast, forward contracts are customized/tailor-made; being so, such contracts can virtually be of any size or maturity.

o   Mode of Trading: In the case of forward contracts, there is a direct link between the firm and the authorized dealer (normally a bank) both at the time of entering the contract and at the time of execution. On the other hand, the clearinghouse interposes between the two parties involved in futures contracts.

o   Liquidity: The two positive features of futures contracts, namely their standard-size and trading at clearinghouse of an organized exchange, provide them relatively more liquidity vis-à-vis forward contracts, which are neither standardized nor traded through organized futures markets. For this reason, the future markets are more liquid than the forward markets.

o   Deposits/Margins: while futures contracts require guarantee deposits from the parties, no such deposits are needed for forward contracts. Besides, the futures contract necessitates valuation on a daily basis, meaning that gains and losses are noted (the practice is known as marked-to-market). Valuation results in one of the parties becoming a gainer and the other a loser; while the loser has to deposit money to cover losses, the winner is entitled to the withdrawal of excess margin. Such an exercise is conspicuous by its absence in forward contracts as settlement between the parties concerned is made on the pre-specified date of maturity.

o   Default Risk: As a sequel to the deposit and margin requirements in the case of futures contracts, default risk is reduced to a marked extent in such contracts compared to forward contracts.

o   Actual Delivery: Forward contracts are normally closed, involving actual delivery of foreign currency in exchange for home currency/or some other country currency (cross currency forward contracts). In contrast, very few futures contracts involve actual delivery; buyers and sellers normally reverse their positions to close the deal. Alternatively, the two parties simply settle the difference between the contracted price and the actual price with cash on the expiration date. This implies that the seller cancels a contract by buying another contract and the buyer by selling the contract on the date of settlement.

In view of the above, it is not surprising to find that forward contracts and futures contracts are widely used techniques of hedging risk. It has been estimated that more than 95 per cent of all transactions are designed as hedges, with banks and futures dealers serving as middlemen between hedging Counterparties.