What are forwards and futures?

Forwards and futures are financial contracts that allow buyers and sellers to agree on the price of an asset to be delivered and paid for at a future date. These contracts are used for hedging, speculation, and arbitrage purposes, and while they are similar, there are key differences in their structure, trading, and use.

Forward contracts are private agreements between two parties, typically traded over-the-counter (OTC) rather than on an exchange. This gives the parties flexibility to customize the terms of the contract, including the amount, price, and settlement date. Since forwards are OTC contracts, they carry counterparty risk—the risk that one party may default on the agreement. This risk is higher compared to futures, which are standardized and traded on exchanges.

Futures contracts are standardized agreements to buy or sell an asset at a predetermined price on a specific date. These contracts are traded on organized exchanges, such as the Chicago Mercantile Exchange (CME). The standardization includes contract size, expiration dates, and the quality of the asset.

Futures contracts are marked-to-market daily, meaning that gains and losses are settled at the end of each trading day. Both buyers and sellers must maintain a margin account to cover potential losses, with margin requirements set by the exchange. If the margin falls below a certain level due to adverse price movements, a margin call is issued, requiring the trader to deposit additional funds.

Forward and Future contracts are invested in by the portfolio managers to hedge various risks to their portfolios and for income generation, experienced traders as speculators to make profit. Both require initial and maintenance margin requirements. Forwards and Future contracts are suitable for those investors who have a much higher risk-taking ability and aptitude.