When it comes to trading in financial markets, forward and future contracts are two commonly used terms. At first glance, these contracts may seem similar, but there are key differences between them. Let`s take a closer look.
What is a Forward Contract?
A forward contract is a private agreement between two parties to buy or sell an asset at a specified price and date in the future. It is a non-standardized contract where the terms and conditions of the contract are negotiated between the two parties involved. The contract is binding, and both parties are obligated to fulfill their end of the agreement.
For example, let`s say you are a farmer who wants to sell your crop at a future date. You enter into a forward contract with a buyer to sell your crop at a specified price on a particular date. In this case, both you and the buyer are committed to the contract regardless of what happens to the market price of the crop in the future.
What is a Future Contract?
A future contract is a standardized contract traded on an exchange. It is similar to a forward contract in that both parties agree to buy or sell an asset on a specific date in the future at a pre-determined price. However, future contracts have standardized terms, such as the contract size, the delivery date, the settlement method, and the underlying asset. All transactions are made through the exchange, and the clearinghouse guarantees the performance of the contract.
For example, let`s say you want to invest in gold. You would buy a gold future contract that stipulates the price, contract size, and delivery date. This contract can be traded on an exchange and can be bought or sold by someone else. The contract will be settled at the delivery date, and the exchange will ensure that the contract is fulfilled.
What are the Differences?
The primary difference between forward and future contracts is standardization. Forward contracts are negotiated between two parties, and the terms of the contract can be customized to the needs of both parties. In contrast, future contracts are standardized contracts traded on an exchange, with predetermined terms that cannot be altered.
Another difference is the level of risk involved. Forward contracts are not regulated, and there is a risk of default by either party. In contrast, future contracts are traded on exchanges, and the clearinghouse guarantees the performance of the contract, reducing the risk of default.
Both forward and future contracts have their pros and cons. Forward contracts offer more flexibility, but they are also less regulated and carry a higher risk of default. Future contracts offer less flexibility but are more secure and regulated. Ultimately, the choice between the two will depend on your trading strategy and risk tolerance.