Forward Contract vs Future Contract

Written by Manwendra Singh

Updated Feb 04, 2025

A forward contract and a future contract are both commonly used by traders to manage risks related to price fluctuations, but they have distinct features that make them suitable for different situations. While both types of contracts allow the buying or selling of an asset at a future date for a predetermined price, the way they are structured and traded varies.

In this article, we will discuss the difference between forward and future contracts and help you understand their unique features and uses.

What is a Forward Contract?

A forward contract is an agreement between two parties to buy or sell an asset at a specific price on a future date. It allows flexibility in terms of what will be delivered and when, along with other customizable factors. To understand this better, let’s consider an example.

Neha wants to sell apples at the current price of Rs. 50, but she thinks that some factors could lead to a fall in apple prices in the coming months. So, she decides to enter into a forward contract with a fruit vendor. The deal states that the vendor will buy apples for Rs. 50 after four months. The vendor won't lose any money if the apple price falls to Rs. 50. However, the vendor will only get the agreed-upon price if apple prices rise.

Features of a Forward Contract

Here are the essential features that make forward contracts a valuable trading option:

Customizable Terms: Forward contracts allow parties to tailor terms like asset type, quantity, and delivery date.
Privately Negotiated: These are over-the-counter agreements, not traded on exchanges.
Settlement Options: Parties can choose between physical delivery of assets or cash settlement, depending on their preferences and needs.
Effective Hedging Tool: Forward contracts are often used to manage risks, protecting businesses from future price changes or interest rate fluctuations.
No Margin Requirements: Unlike futures, forward contracts don’t require an upfront margin.

Advantages and Risks of a Forward Contract

A forward contract offers several advantages. However, like any financial instrument, it also comes with its own set of risks.

Advantages

Hedging: Forward contracts allow parties to lock in a specific price, protecting themselves from potential market fluctuations. This preset agreement helps manage risks associated with price changes in the underlying asset.
Customization: Forward contracts offer a high degree of flexibility. The terms such as the contract's expiry date, lot size, and pricing can be customized according to the needs and preferences of the parties involved.
Simplicity: The simplicity of a forward contract lies in its basic structure. Traders and investors can easily understand how the price protection works. These contracts allow for a more straightforward approach to risk management and trading with fewer regulatory constraints.

Risks

Regulatory Risk: Forward contracts are made by mutual consent between the two parties. They are not regulated by a central authority, unlike futures contracts. This lack of regulation increases the possibility of one party failing to meet their obligations, leading to higher default risks.
Liquidity Risk: Liquidity in forward contracts is often limited since they are not traded on public exchanges. This low liquidity can make it difficult for parties to enter or exit positions as they wish, even if they have a strong trading strategy.
Default Risk: As forward contracts are private agreements, there is always the risk that one party may not fulfill the terms of the contract. If a party defaults or fails to settle, the other party may face significant financial loss. This exposure to default risk is inherent in over-the-counter (OTC) markets.

What is a Future Contract?

A future contract is an agreement to buy or sell an asset at a fixed price on a future date. It is traded on a futures exchange and involves a middleman to ensure the deal goes smoothly. The middleman helps reduce the risk of either party failing to meet their obligations. Let’s look at an example to understand it better.

Alex and Priya are two individual parties. Alex is a wheat farmer, and Priya owns a bakery that regularly uses wheat. Priya agrees to purchase a certain amount of wheat (say, 100 kg), and both parties agree to a fixed price (say, Rs. 25/kg) for trading the wheat on a future date. The futures contract will be executed at the agreed-upon price at the delivery time, regardless of the market price on the expiration date.

Features of a Futures Contract

Let’s take a closer look at the key features that define future contracts:

Standardized Terms: Future contracts come with fixed terms, including asset quantity, quality, and delivery date.
Exchange-Traded: These contracts are traded on organized exchanges.
Margin Requirements: Traders need to deposit an initial margin and maintain a specific balance as collateral.
Leverage: Futures allow traders to control large asset positions with a relatively small initial investment.
Real-Time Pricing: Up-to-date market prices ensure fair and transparent trading decisions.
Daily Settlement: Profits and losses are calculated daily, reducing risks by settling trades at the end of each day.
Settlement Flexibility: Depending on the agreement, contracts can be settled through physical delivery or cash payments based on price differences.
Expiration Dates: Each contract has a set expiration date, ensuring clarity and planning for all parties.
Wide Asset Range: Future contracts cover various assets, from commodities and financial instruments to stock indices, catering to diverse needs.

Advantages and Risks of a Future Contract

Futures contracts provide benefits that help traders and investors manage risks and explore market opportunities. However, they also have their own risks.

Advantages

Market Price Exposure: One of the most significant advantages of futures contracts is that they allow investors to gain exposure to futures prices linked to the cost of an underlying asset in the market. This gives them the opportunity to profit from price movements without needing to own the actual asset.
Hedging: Futures contracts are commonly used by traders for hedging purposes. By locking in prices today, they can protect themselves from potential price drops in the future, reducing the risk of financial losses caused by market volatility.
Leverage: Another advantage of futures contracts is the ability to use leverage. Traders only need to deposit a margin, a fraction of the total contract value, which allows them to control larger positions with less capital upfront. This can enhance potential returns.

Risks

Margin Risk: While leverage can amplify profits, it also exposes investors to margin risks. If prices move in the opposite direction of the position, investors could lose the initial margin they deposited, leading to significant losses.
Limited Price Flexibility: When entering a futures contract, investors may miss out on desirable price fluctuations. If the market moves in their favour, they are locked into the contract terms, which may prevent them from capitalizing on favourable market conditions.
Potential Losses with Margin: Using margin in futures contracts can lead to greater losses than the initial investment. If the market swings unfavourably, the trader may be required to provide additional funds to maintain the position, leading to potential financial setbacks.

Forward Contract vs Future Contract

When it comes to trading, understanding the difference between forward contracts and futures contracts is essential. Let’s explore the forward Contract vs future Contract comparison in detail:

Parameter	Forward Contract	Futures Contract
Regulation	Forward contracts are privately negotiated between two parties and typically lack external regulatory oversight.	Futures contracts are regulated by national financial authorities and exchanges, ensuring that both parties adhere to market rules.
Collateral/Margin	No initial margin or collateral is required for forward contracts. The contract is based on mutual trust, which can make them riskier.	Futures contracts require an initial margin to be posted as collateral. This margin is regulated by exchanges, ensuring that both parties have the financial capacity to meet their obligations.
Trading Venue	Forward contracts are traded over-the-counter (OTC), meaning they are negotiated privately between two parties without being listed on public exchanges.	Futures contracts are traded on formal exchanges, which provide easy access, high liquidity, and a transparent trading process for all market participants.
Settlement Type	Settlement of forward contracts is typically agreed upon at the time of contracting, either in cash or through physical delivery, with the settlement happening at maturity.	Futures contracts are settled daily through a process called mark-to-market, where profits and losses are realized and adjusted at the end of each trading day.
Liquidity	Forward contracts typically have low liquidity. Since they are customized and traded OTC, there is no secondary market for them. This makes it difficult to exit or adjust positions once entered.	Futures contracts enjoy high liquidity due to the standardized nature and centralized exchanges. This liquidity allows for easy entry and exit of positions at any time before the contract's expiration.
Pricing Mechanism	The price of forward contracts is negotiated directly between the two parties involved. There is no centralized price discovery, which can lead to pricing inefficiencies.	Futures contracts are priced through centralized exchanges, with market participants collectively determining the price. This process ensures an efficient and transparent price discovery mechanism.
Contract Maturity	The maturity date of forward contracts is flexible and can be decided by mutual agreement between the two parties, making it adaptable to specific needs.	Futures contracts have a fixed maturity date, which is determined by the exchange when the contract is created. This fixed expiration date ensures consistency in the contract's terms.
Flexibility	Forward contracts are highly flexible, allowing for adjustments to key contract terms, including asset type, delivery date, and quantity, as required by the parties.	Futures contracts are rigid and cannot be adjusted once set. The terms are standardized by the exchange, which reduces flexibility but ensures consistency.
Margin Calls	There are no margin calls for forward contracts. The financial responsibility is solely on the parties involved, which increases the risk of default.	Futures contracts are subject to margin calls if the market moves unfavorably. Traders must maintain the required margin to keep their positions open, minimizing the risk of default.
Counterparty Risk	Forward contracts have a higher counterparty risk due to the absence of an intermediary. If one party defaults, the other party may not recover the full value of the contract.	Futures contracts are protected from counterparty risk because exchanges act as intermediaries, guaranteeing the performance of both parties.
Settlement Date	Forward contracts have a negotiable settlement date based on the terms agreed upon by the two parties, providing flexibility in timing.	Futures contracts have a fixed settlement date predetermined by the exchange, meaning traders must adhere to this fixed timeline.
Regulatory Oversight	Forward contracts are not subject to any formal regulatory oversight, leading to less protection for the parties involved.	Futures contracts are tightly regulated by exchanges and financial authorities, providing a structured and safe environment for market participants.
Cost of Trading	Forward contracts are generally more cost-effective as they do not involve exchange fees, clearing fees, or other associated costs. However, the negotiation process can be complex.	Futures contracts incur various fees such as exchange fees, clearing fees, and commissions. While these costs can add up, they are more predictable and structured compared to forward contracts.
Use in Speculation	Forward contracts can be used for speculative purposes, especially when a custom position is required. However, the lack of liquidity makes this less practical for short-term speculation.	Futures contracts are commonly used for speculation due to their high liquidity, transparency, and standardized nature, making them ideal for short-term traders looking to profit from price movements.

Conclusion

When considering forward contract vs future contract, it's essential to understand how these financial instruments differ in regulation, risk management, and settlement processes. Forward contracts provide flexibility and customization but lack the regulatory framework of futures. On the other hand, futures contracts stand out for their transparency, liquidity, and daily settlement mechanisms.

By understanding the difference between forward and future contracts, traders can choose the instrument that aligns with their financial goals and risk appetite, ensuring smarter investment decisions.

Written by Manwendra Singh

Manwendra Singh is a budding marketing professional with a focus on content marketing. He currently holds the position of Executive at InsuranceDekho, where he uses his skills and the learnings of insurance to create content that informs and engages with the readers.Read More

Disclaimer

This article is issued in the general public interest and meant for general information purposes only. Readers are advised not to rely on the contents of the article as conclusive in nature and should research further or consult an expert in this regard.