Comparing Futures and Forward Contracts
Futures contracts are special types of contracts that obligate the seller to deliver the commodity on a specific date in the future. For this reason, many people confuse futures contracts with forward contracts. While the basic concepts are similar, there are actually many differences between futures contracts and forward contracts.
One of the primary differences between a futures contract and a forward contract is the fact that forwards can only transact when they are purchased and on the settlement date. When it comes to futures, however, the can actually rebalance every day. Since forwards cannot rebalance, it is possible for a large differential to develop between the delivery price and the settlement price. This is particularly true if the price of the underlying asset changes drastically. As a result, investment in a forward contract is far riskier than forwards.
Since futures are rebalanced on a daily basis, the credit risk of this type of investment is virtually eliminated. This is because the person holding the futures contract must update the price to be equivalent to how much a forward would be purchased for on the same day. As a result, the amount of additional money that is due on the settlement day is usually very small. Furthermore, the futures-settlement failure risk is actually carried by the exchange rather than by the individual.
Another difference between forwards and futures is the fact that futures can only be traded on an exchange. Forwards, on the other hand, are always traded over-the-counter or by simply having the two parties sign a contract. Since futures must be traded on an exchange, the exchange acts as the counter party for the trade. Yet, the exchange does not have a net position, which means the buyer and seller actually do not know who they traded to. Since forwards are completed over-the-counter or through a contract signed by both parties, the buyer and seller work directly with each other in order to complete the exchange.
The fact that futures are very standardized also sets them apart from forwards. Although some forwards can be standardized, some are also unique. Furthermore, if the contract has to be physically delivered, forward contracts specify precisely who the delivery must be made to. The entity receiving the futures contract, on the other hand, is selected by the clearinghouse. The clearinghouse is a company that specializes in financial services and provides clearing and settlement services for futures transactions and other financial transactions.
Although the basic concept behind futures and forwards is quite similar, there are many subtle differences that must be considered when making an investment in these types of contracts. Most importantly, you need to weigh the risks associated with each type of contract in order to determine which is the best type of investment for you. If you are willing to take a risk, forwards might be right for you. If you are interested in an investment with very little risk and that is easy to complete, however, futures contracts might be a better choice.