Which one of the following is a difference between a forward contract and a futures contract?
Professional investors who have been investing for numerous years swear by learning about the important trading techniques and strategies If anyone wants to create a robust investment portfolio. Among numerous
investment instruments and trading techniques that can allow investors to ensure a profitable portfolio, derivatives trading is a key technique. However, investors can use numerous derivative instruments to achieve their portfolio goals. Since the amount of money involved in derivative trading is always significantly high, it is vital that you first understand the types of derivatives in detail. One thing that confuses almost every beginner derivative investor is the difference between
Forwards and Futures contracts. This blog will attempt to provide knowledge about the difference between the two derivative contracts and let you pick the ideal one before you start trading. But first, a little about derivatives trading. Fundamentally, derivative trading is conducted based on the price movement of the derivative product’s underlying asset. These assets could be stocks, currencies, bonds, commodities, and so on. There are two types of
derivative trading: standardised financial contracts with stock exchange as a counter-party, and private contracts between parties, without a formal intermediary. While the former is known as Exchange Traded Derivatives, the latter is called
Over-the-Counter (OTC) derivative trading. A future contract, also known as futures, is a standardised financial contract traded through stock exchanges. Under a futures contract, a predetermined quantity and
price are agreed upon, payable at a specific future date. The parties in a futures contract are legally bound to exercise the contract. In a futures contract, the standardised terms and conditions include: Consider the following example of a futures contract with currency as the underlying asset, known as FX Future. Using a
currency futures contract, you can exchange one currency with another on a given date in the future at a rate fixed on the date of the purchase. In India, you can use the future contracts on four pairs of currencies: Furthermore, you can also use futures contracts to trade in other segments, like commodities and stocks. A forward contract, also known as forwards, is a private agreement between two parties to purchase or sell the underlying asset at a predetermined time at a specific price. You can learn about the profit or loss accruing from a forward contract only at the date of settlement of the contract. A forwards contract is available for trading
in different OTC derivatives, such as stocks, commodities, and so on. For instance, in India, you can have a forward contract for currencies, which are outside the specified list by stock exchanges and are managed and regulated by the two private parties. You can refer to the chart given below to understand the key differences between the two contracts.
Other Key Differences:Structure, Scope And PurposeA futures contract is subject to standardisation and uniformity, besides the requirement of margin payments. Conversely, the terms of trade are flexible in a forward contract and can be negotiated to fit the requirements of the trading parties. While futures are highly liquid, forwards are typically low on liquidity. ETF Futures are typically more active in segments, like stocks, indices, currencies and commodities, while OTC Forwards usually sees larger participation in currency and commodity segments. Transaction MethodA futures contract is regulated by the framework or rules provided by the government. On the other hand, a forwards contract is directly negotiated between the buyer and the seller without the involvement of any government-approved intermediary. Hence, the transaction method for futures contracts is managed through the stock exchanges, while forwards contracts execute transactions as per the negotiated terms of the two parties. Price Discovery Mechanism/PricingStandardisation in futures contracts allows for an efficient price discovery mechanism. However, the absence of a centralised framework results in an inefficient price discovery mechanism for forwards contracts in a completely informal market. While the price of futures contracts is transparent, forwards have opaque pricing dictated by the two agreeing parties. Risks InvolvedForwards contracts are subject to counterparty risks where one of the parties can refuse to honour the terms of the agreement at the time of settlement. Besides, forwards contracts are also subject to default risk owing to a trading party not settling the dues on the specified date. Future contracts, however, do not pose any counterparty risks as the stock exchange acts as a regulatory body for all the parties. Furthermore, all the market positions are recorded by the stock exchange after the end of the daily trading session, known as a Marked-to-Market settlement. As the contract terms bind the trading parties through the stock exchange, there is no risk of default in payment on the maturity date. ConclusionAfter knowing the difference between a futures and a forwards contract, you can now commence your investment journey with clarity and confidence. However, before you start investing, you should understand that a trusted and reliable financial partner can play a key role in ensuring that you make wise investment decisions. Remember, a reputed broking firm can provide you manifold advantages such as zero Demat account and trading account opening fees, zero Demat AMC for one-year, cutting-edge trading platforms and mobile apps and a single account for all investment options. Related Articles |