What is a Future? What is a Forward? What is the Difference Between Them?

Futures and forwards are financial derivatives that derive their value from an underlying asset. They are contracts between two parties to buy or sell the asset at a predetermined price on a specified future date. While they share similarities, there are key differences between futures and forwards:

Futures

• Standardized Contracts: Futures contracts are standardized agreements traded on organized exchanges, such as the Chicago Mercantile Exchange (CME) or Eurex. They have fixed contract sizes, expiration dates, and other terms set by the exchange.
• Exchange-Traded: Futures are traded on centralized exchanges, providing liquidity and a transparent marketplace. They are standardized to facilitate easy trading between parties.
• Margin Requirements: Futures contracts require participants to deposit an initial margin with a clearinghouse. Additionally, daily mark-to-market adjustments may be made, requiring participants to either deposit more money (margin call) or receive a credit.
• Counterparty Risk: The clearinghouse acts as an intermediary, reducing counterparty risk. Participants don't need to worry about the creditworthiness of the other party; they face the clearinghouse.
• Liquidity: Futures contracts are generally more liquid than forwards due to standardized features and the presence of an organized exchange.
• Marking to Market: Futures contracts are marked to market daily, and gains or losses are settled each day. This mitigates the risk of one party defaulting on the contract.

Forwards

• Customized Contracts: Forward contracts are private agreements between two parties, and their terms can be customized to fit the specific needs of the participants. This flexibility allows for tailored agreements.
• Over-the-Counter (OTC) Trading: Forwards are traded directly between the two parties involved. There is no centralized exchange, and terms are negotiated between the buyer and the seller.
• No Margin Requirements: Since there is no clearinghouse involved, there are no initial margin requirements or daily mark-to-market adjustments in forward contracts. Payments are typically made at the end of the contract term.
• Counterparty Risk: Forward contracts expose participants to counterparty risk. If one party defaults, the other may face challenges in enforcing the contract and recovering losses.
• Customization: The lack of standardization allows for flexibility in the terms of the contract, but it can also make it harder to find a counterparty with matching requirements.
• Settlement: Settlement in forward contracts occurs at the end of the contract term, and the buyer pays the agreed-upon price to the seller, who delivers the underlying asset.

Both futures and forwards serve as risk management tools and allow market participants to hedge against price fluctuations in various assets, including fixed income, commodities, currencies, and financial instruments. The choice between futures and forwards depends on factors such as the need for customization, liquidity preferences, and the willingness to manage margin requirements and counterparty risk.