A futures contract and a forward contract are both agreements to buy or sell an asset or commodity at a predetermined price and date in the future. However, there are some important differences between the two.
- Standardization: Futures contracts are standardized contracts traded on a futures exchange, with standardized terms for delivery date, quantity, and quality of the underlying asset. Forward contracts, on the other hand, are customized agreements negotiated between two parties with specific terms that may not be standardized.
- Counterparty Risk: Futures contracts are traded on an exchange, which acts as a counterparty to both the buyer and the seller, ensuring that both parties fulfill their obligations. In contrast, forward contracts are private agreements between two parties, which exposes them to counterparty risk if the other party fails to fulfill their obligation.
- Liquidity: Futures contracts are traded on an exchange, which provides a high degree of liquidity and transparency. Forward contracts, being private agreements, are not traded on an exchange, making them less liquid and more difficult to sell.
- Margin requirements: Futures contracts are typically traded with margin requirements, which require traders to put up a small percentage of the contract value as collateral. This helps to ensure that both parties fulfill their obligations. In contrast, forward contracts do not typically have margin requirements.
- Mark-to-Market: Futures contracts are marked-to-market daily, which means that the profit or loss on the contract is settled on a daily basis. In contrast, forward contracts do not have daily mark-to-market settlements and the profit or loss is settled on the delivery date.
In summary, futures contracts are standardized contracts traded on an exchange with standardized terms and high liquidity, while forward contracts are private agreements between two parties with customized terms and lower liquidity.