Futures contracts and forward contracts are agreements to buy or sell an asset at a specific price at a specified date in the future. These agreements allow buyers and sellers to lock in prices for physical transactions occurring at a specific future date to mitigate the risk of price movement for the given asset through the date of delivery.
Historically, a forward contract set the terms of delivery and payment for seasonal agricultural commodities, such as wheat and corn, between a single buyer and seller. Today, forward contracts can be for any commodity, in any amount, and delivered at any time. Due to the customization of these products they are traded over-the-counter (OTC) or off-exchange. These types of contracts are not centrally cleared and therefore have a higher rate of default risk.
The futures market emerged in the mid-19th century as increasingly sophisticated agricultural production, business practices, technology, and market participants necessitated a reliable and efficient risk management mechanism. Eventually, the exchange model established for agricultural commodities expanded to other asset classes such as equities, foreign exchange, energy, interest rates, and precious metals.
The modern futures exchange has evolved over time and continues to serve the needs of traders and other users. Futures contracts are used by traders today in many ways. Traders will often use futures contracts to directly participate in a move up or down in a particular market, without having any need for the physical commodity. Traders will hold their positions for various lengths of time, ranging from day trading to longer term holdings of weeks to months or longer.
Differences Between Futures and Forwards
Consider the following differences between futures contracts and forward contracts. There are many advantages that futures contracts provide traders.
| Futures | Forwards |
|---|---|
| Traded on exchange | Privately negotiated |
| Standardized, having an exchange-specified contract unit, expiration, tick size, and notional value | Customized |
| No counterparty risk, since payment is guaranteed by the exchange clearing house | Credit default risk, since it is privately negotiated, and fully dependent on the counterparty for payment |
| Actively traded | Non-transferrable |
| Regulated | Not regulated |
Characteristics of the futures contract including standardized terms, transferability, the ease with which one can enter and exit a position, and elimination of counterparty risk, all of which have attracted a large number of market participants and established the futures exchange as an integral component of the global economy.
What once was an agricultural exchange has grown and now allows traders access to many unique markets like interest rate futures, sector specific contracts, foreign currency contracts, and more. These trading opportunities are only offered through the futures exchange.
Summary
With the addition of trades using options on futures, two expiries per week, even more strategies and products are now available, which leads to continued popularity for individual and institutional traders alike.
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