A forward contract involves two entities who agree to swap one asset for another at a future predetermined price. The only option to purchase and sell privately is through OTC. Futures are packaged in standardized sizes and traded in open markets. Both of them share a key similarity in that the dates of the transactions and the prices of the assets are agreed upon beforehand.
In addition, the two contracts serve as tools for locking in prices for the future. Therefore, they are essential in reducing the risk of price fluctuations in the future. Many traders and investors, therefore, use them as hedging tools. Later price movements may go against a trader’s position for forwards, leading to losses.
It’s possible to purchase and sell commodity forward contracts at any time of the day or night, in any number, and in any size. They are swapped off-exchange or over the counter, which means that they may be tailored to meet specific requirements. While the ability to customize them makes them an appealing alternative for specific traders, the OTC component prevents many potential investors who are not aware of it from participating.
The biggest points of divergence among the instruments are in the markets in which the trades occur and the degree of flexibility in each. As highlighted above, forward trades take place OTC, while in futures, the execution takes place in public exchanges.
When it finally reaches maturity time for forwards, one of the parties makes a profit at the expense of the other. For sellers, they will incur a loss if, at maturity, the current market price exceeds the contract price. Conversely, if the current price exceeds the contract price, the buyer will lose. In this case, the transaction is often settled in cash.
Also, because futures trading takes place on exchanges, anybody can access them, rather than just two parties, as is the case with forwards.
They are also comparable to stock exchanges in that they list tradable assets in the same manner that stocks are listed on a stock exchange. The standardization process incorporates all of the components that have been standardized. There are several of these, including the cost and delivery date.
Below is a look at the critical elements of divergence between the two approaches to commodities.
Futures are fixed in size, whereas forwards contracts are more flexible. Because of this, traders looking for more leeway in determining how much they want to trade will favor futures. However, their contract sizes may be prohibitive for certain participants, depending on their objectives or available capital.
For traders to exchange their daily profits and losses through their margin accounts at the end of each working day, the price of a futures contract is reset to zero at the end of each trading day. In contrast, the value of a forward does not begin to diminish or grow until it reaches maturity, depending on how long it has been since the deal was signed.
In a forward contract, the counterparty risk is significantly high. If you’re dealing with forwards, you risk losing your money in case the other party fails to honor their contractual obligations. There is no danger of default while trading futures because a clearinghouse covers it.
Margin is a percentage of the value of the contract in futures transactions held by a broker in a futures trade. This provides a safety net for brokers when a trader loses money.
Clearinghouses mitigate that risk by taking stakes on both sides of a deal in futures. Traders may be specific that they have enough money in their margin accounts to cover their wagers each day. This is an assurance.
For investors who trade daily, losses are their own responsibility. A margin call is issued if an investor’s margin account balance falls below the defined minimum.
Which is the better choice?
Futures may be a better option for the average investor when it comes to making investment decisions. There may be fewer possibilities to invest in forwards since private transactions are inherently scarce.
You may find the flexibility that comes with forwards more appealing. The ability to customize the terms to both parties’ satisfaction is undoubtedly one that is worth considering. The downside to this is the risk of default that comes with agreements signed OTC.
A derivative investment, such as a future or a forward, is one whose value is derived from the value of the connected assets. No matter which of the assets you’re dealing with, you should transact in a certain future time.
As a result of this, there are several variances between the two instruments. Forwards carry a comparatively higher risk of default. As a result, hedging is the most appropriate application for forwards. Futures are ideally suited to speculative endeavors.