Futures contracts are similar to forward contracts, where two parties agree to buy or sell an underlying asset at a predetermined price on a pre-specified date.
The key difference between the two is that unlike a forward contract, which is traded over-the-counter, a futures contract is traded on an organized exchange.
Just like a forward contract, a futures contract can also be deliverable or cash settled. Because a futures contract is traded on an exchange, it gives rise to a few more differences between futures and forwards.
The following is a list of key differences:
- Futures contracts are traded on an exchange while forward contracts are privately traded.
- Since they are traded on exchange, futures contracts are highly standardized. Forward contracts, on the other hand, are customized as per the requirements of the counterparties.
- A single clearinghouse acts as the counterparty for all futures contracts. This means that the clearinghouse is the buyer for every seller and seller for every buyer. This eliminates the risk of default, and also allows traders to reverse their positions at a future date.
- Futures contracts require a margin to be posted at the contract initiation, which fluctuates as the futures prices fluctuate. There is no such margin requirement in a forward contract.
- The government regulates futures market while the forward market is not regulated.
In a futures contract, the buyer of the contract is said to have a long position and the seller is said to have a short position. The long is required to buy the underlying asset as per the specified time and price and the short is required to deliver this underlying asset.
In terms of standardization, the futures markets have specifications for various things such as the quality of the underlying asset, quantity, delivery dates, price movements, etc. For example, 100 shares of a company may form one futures contract.
Futures contracts are used by both speculators to gain market exposure, and hedgers to mitigate their risks or reduce their exposure to price changes.