Forwards and futures are both types of derivative contracts. They are agreements between two participants to buy or sell an underlying asset for a predetermined price on an eventual date. With that said, they also have some major differences that are important to distinguish. A forward is an unregulated, personalized, and private agreement, whereas a future is the opposite — highly regulated, standardized, and public. There are applications and reasons for both types of contracts.
The most practical use of a forward contract is when two parties need to make an agreement on their own terms. Say, for example, a restaurant owner wants to know the exact price they’ll pay for corn in six months. They may decide to contact a farmer and negotiate a forward contract. The two participants will decide on conditions such as delivery, time frame, and payment for the asset. No other party needs to be involved in this negotiation. Since a centralized exchange is not used, this would be referred to as an over-the-counter (OTC) agreement. When six months pass by, the farmer supplies the corn to the restaurant owner for the predetermined price.
It can be the perfect scenario for both sides, but there are some risks you need to consider. The most prominent is counterparty risk — the dependency and reliability of the other participant to uphold their obligations.
This uncertainty is eliminated within a futures contract. As forwards are traded over the counter, futures are exchange-traded. What this means is that a regulated body is now involved in the arrangement and will ensure secure, standard, and transparent practices. They also provide traders with preset, standardized contracts. Some of the most popular future exchanges are the Chicago Mercantile Exchange (CME), Chicago Board of Trade (CBOT), New York Mercantile Exchange (NYMEX), London Metal Exchange (LME), and Tokyo Commodity Exchange (TOCOM). They all specialize in different types of underlying assets and commodities.
The benefits and disadvantages of futures may have become apparent to you. While there is no longer counterparty risk, there is also less flexibility to customize the contract to your liking.
A future may not be the best option for the restaurant owner, but it would be for a speculator who believes the S&P 500 stock index is going to rise over the next two years. If proven to be correct, they would be rewarded with a profit. To complete the transaction, a purchase order needs to be placed with their broker. The broker then passes it to the exchange’s clearinghouse, as it keeps all records of requests. If the clearinghouse finds a seller who is willing to balance the other side, the order will be accepted.
If at some point the speculator no longer believes the index will rise, they can offset their current position by submitting a sell order. Once the clearinghouse has accepted the order, the speculator is no longer responsible for the contract. Unbeknown to the participants, a futures contract can exchange hands thousands of times before the delivery date.
Offsetting a trade can be extremely difficult for the buyer of a forward contract. Given that the agreement is customized to their terms, it may not fit the needs of others. Also, the buyer would have to find another party all on their own. That is the advantage of having an exchange doing all this work on our behalf.
As you can see, both types of derivatives have similarities but more significant differences. Before you obligate yourself to either, take some time to consider their pros and cons. Do you want flexibility with more risk or regulation with stricter provisions? Either way, forwards and futures can be a great option to speculate or manage uncertainty over time.