Contrasting Forwards and Futures - VRK100 - 31Aug2012

Contrasting Forwards and Futures

In financial markets across the globe, trillions of dollars of derivative transactions take place on a daily basis round the clock – right from New York, Chicago, London, Shanghai, Bombay, Hong Kong, to Singapore.

Forwards and futures are important building blocks of derivative transactions. The following easy-to-understand table describes the important differences between forward and futures contracts. And later, the article briefly explains their general uses, types and salient features.

	Forwards	Futures
1	They are customized products	They are standardized products
	to suit individual needs - they	dealt on stock exchanges
	serve specialized clientele
2	In general, there is no mark-to-	Mark-to-market is done on a
	market of contracts	daily basis providing interim
		cash flows
3	No cash changes at the start	A small margin needs to be paid
	of a transaction	at the start of a transaction
4	The contract size depends on	The contract size is fixed and
	the needs of clients	uniform
5	Counterparty risk exists in	The stock exchange bears the
	forwards (credit risk exists)	counterparty risk (no credit risk)
6	They are bilateral contracts,	They are multiparty contracts,
	that is, between two parties	involving many parties
7	They are lightly regulated	They are well regulated

Definition and Salient Features

A forward contract (or simply a forward) is a financial contract between two parties in which one party, the buyer, agrees to buy an underlying asset from the other party, the seller, an underlying asset at a rate agreed at the start of the contract and to be settled on a future date.

In contrast, a futures contract is a financial contract traded on a recognized stock exchange to buy or sell an underlying asset, at a price determined on the starting date of the contract, and to be settled on a specified future date, but does not include a forward contract.

The underlying asset can be an equity share or an equity index, a commodity or a commodity index, a currency, or an interest rate like the LIBOR that is London inter-bank offered rate.

The salient features of a futures contract include maturity date, size or amount of the contract, the currency in which the contract is denominated, settlement price and the method of settlement.

As described in the above table, forward contracts are not traded on stock exchanges, but futures are. In a futures contract, the stock exchange acts a central counterparty to all the deals and as such the parties have no counterparty or credit risk. On the other hand, forwards carry credit risk as the counter party may default at the maturity date of the contract.

Uses and benefits of forwards and futures

Multi-national companies and many other corporates are exposed to various types of risks, ranging from volatile currency movements, ever-changing interest rates, to oscillating commodity prices. Such companies undertake derivative transactions to hedge, that is, especially to reduce or mitigate an existing identified risk using derivatives, such as, futures, forwards, swaps or options.

In addition, there are market-makers who can undertake derivative transactions to act as counterparties in derivative transactions with users and also amongst themselves. They would try to exploit the market movements and provide quotes.

Forward and futures contracts serve the purpose of risk management, facilitate efficient price discovery, enable better counterparty credit risk management and reduce transaction costs. Futures are used by speculators also to exploit arbitrage opportunities in markets. Globally, futures markets are more transparent and their volumes are much higher compared to forward markets.

Main types of forward or futures contracts

There are various kinds of forwards and futures, the important types being the underlying assets based on currencies, commodities, equities and interest rates.

The important types of forward contracts include interest rate forward contracts or forward rate agreements; equity forwards; currency forwards; and fixed-income forward contracts. A forward rate agreement (FRA) is a specialized type of forward contract used to hedge an exposure to interest rates or to exploit a view on future interest rates.

Currency futures, stock futures, index futures, bond futures, and interest rate futures are major types of futures contracts and are traded on stock exchanges.

Forwards and futures are important building blocks, in the sense that understanding them well will help us in knowing well other types of derivatives, such as swaps, swaptions and options.

A derivative is basically a financial instrument whose value changes in response to the change in an underlying asset and is settled at a future date as agreed between the parties involved. There are two types of derivative contracts, OTC derivatives and exchange-traded derivatives. Over-the-counter derivatives are contracts that are traded directly between two parties, but not through an exchange. In contrast, exchange-traded derivatives are derivative products that are traded on an exchange. For more, please read the relevant articles:

1. Currency futures:

http://ramakrishnavadlamudi.blogspot.in/2009/12/currency-futures-status-check-after-one.html

2. Interest Rate Futures:

http://ramakrishnavadlamudi.blogspot.in/2009/12/interest-rate-futures-irfs-nse.html

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Disclaimer: The author is an investment analyst and writer. His views are personal. He has a vested interest in the stock/bond markets. He may change his views very fast without any notice depending on the market and economic conditions. His views should not be construed as investment recommendation. There is a risk of loss in equity/bond investments. Investors need to consult their certified financial adviser before making any investment decisions.

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