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.
What is 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.
What Is a Futures Contract?
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:
- The volume of trade.
- Delivery date.
- Credit procedure.
- Other technical specifications.
Futures Contract Example
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:
- Indian Rupees and US Dollar
- Indian Rupee and United Kingdom Pound Sterling
- Indian Rupee and Euro
- Indian Rupee and Japanese Yen.
Furthermore, you can also use futures contracts to trade in other segments, like commodities and stocks.
What Is a Forward Contract?
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.
Difference Between Forward And Future Contract
You can refer to the chart given below to understand the key differences between the two contracts.
| Basis | Future Contract | Forward Contract |
|---|---|---|
| Settlement | Daily, by the stock exchange. | On the maturity date as negotiated between the parties. |
| Regulation | Regulated by market regulators such as the Stock Exchange Board of India (SEBI). | Self-regulated. |
| Collateral | Margin requirements as per the stock exchange rules. | Zero requirements of initial margin |
| Maturity | On a predetermined date. | According to the terms of the private contract. |
Other Key Differences:
Structure, Scope And Purpose
A 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 Method
A 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/Pricing
Standardisation 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 Involved
Forwards 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.
Conclusion
After 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 zeroDemat 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.
