University of central Punjab

Assignment No : 3
Topic: Forward VS future contract

Submitted to Prof: Abdul Rehman Makii

Areeba But 0013

Sheeza 0036

Humaira samar 0015

Sareen 0026

Hafsa Awais 0040

Muqdas 0037

DEPARTMENT OF ACCOUNTING AND FIANANC

What Is a Futures Contract?
A futures contract is a legally binding agreement between a buyer and a seller. It defines the
purchase or sale of a specific asset quantity on some forthcoming date.
A futures contract is a standardized financial instrument. This means that it is subject to the
following parameters:
 Quantity: A contract’s quantity is the unit amount of the underlying asset.

 Expiration date: An expiration date is the day on which a contract is no longer offered

for trade.

 Settlement procedure: Depending on whether you’re a buyer or seller, each futures

contract is settled financially or via physical delivery at expiry.

 Price: Futures are priced by the open market and evolve continuously from launch to
expiry.

What Is a Forward Contract?

A forward contract is a binding agreement between a buyer and seller. It governs the purchase or
sale of an asset quantity at a specified price on some forthcoming date.
Forward contracts are customizable derivatives products. They exist as private agreements
between parties and are traded in an over-the-counter (OTC) capacity. However, although
customizable, each includes the following elements:
 Quantity: Participants agree to a predetermined asset quantity.

 Price: Buyers and sellers agree to a specific up-front contract price.

 Expiration date: Like futures, forwards have an expiration date.

 Settlement procedure: Depending on whether you’re a buyer or seller, contracts are

settled financially or via physical delivery.

 Similarities or Relationship between Forward Contract and Futures

Contract:
There is a close relationship between futures contract and forward contract in the foreign
exchange market. A futures contract is an agreement to buy or sell an asset on a specified day in
futures for a specified price. This is more or less similar to forward contract. But there is a
difference between futures contract and forward contracts. Futures contracts are traded on
organized exchanges, using highly standardized rules. But, forward contracts, comparatively do
not have such a rigid system and are informal agreements that vary according to the needs of the
parties.
 Understanding Futures vs Forward Contracts:
Both futures and forwards are similar in their characteristics. These derivatives require a
counterparty to buy or sell an asset at a future date. The price is determined when you purchase
the contract. Such derivatives have multiple applications. For example, if a farmer expects to
sell his crop in 3 months and expects the prices to drop, he can sell futures on his crop to lock in
the selling price. If the price falls below the agreed-upon rate, the farmer does not lose out since
his price has been locked. This is a popular technique that investors refer to as hedging.
Similarly, an investor can buy futures on a stock instead of the actual underlying asset. Using this
option, he can gain exposure to an increased number of shares, because the cost of purchasing a
future on a single share is less than outright buying the same share.
Investing in futures or forwards contracts can be risky and individuals need to understand the
implications before delving into the derivatives market. Especially the leverage characteristics.
You can use these contracts in different asset classes like equity, fixed income, commodity, and
foreign exchange.
 Key Comparison Between Forward and Futures Contract:
The basic differences between forward and futures contract are mentioned
below:
An agreement between parties to buy and sell the underlying asset at a certain price on a future
date is a forward contract. A future contract is a binding contract whereby the parties agree to
buy and sell the asset at a fixed price and a future specified date.
The terms of a forward contract are negotiated between buyer and seller. Hence it is
customizable. Conversely, a futures contract is a standardized one where the conditions relating
to quantity, date, and delivery are standardized.
Forward contracts are traded Over the Counter (OTC), i.e. there is no secondary market for such
contracts. On the other hand, a Futures contract is traded on an organized securities exchange.
When it comes to settlement, forward contracts settle on a maturity date. As compared to the
future contract which is marked to market on a daily basis, i.e. the profit or losses are settled
daily.
There is a high counterparty risk in case of forward contract as compared to a futures contract.
In the case of a forward contract, there are high chances of default by a party, as the agreement is
private in nature. Unlike a future contract, where clearing houses are involved, that guarantees
the transaction, so the possibility of default is almost nil.
If we talk about the size of the contract, in a forward contract, it depends on the terms of the
contract, whereas the size is fixed in case of the futures contract.
The maturity of the contract is as per the contractual terms in the forward contract while the
same is predetermined in the futures contract.
In forward contracts, there is no requirement of collateral, but in futures contracts, initial margin
is required.
Forward contracts are self-regulated. Unlike futures contracts, which are regulated by the
securities exchange.
 Difference between forward contract and future contract:
1. Purpose: Forward contracts are almost always held until expiration and physically settled
because the counterparties are interested in exchanging the underlying asset for cash.
 Physically settled future contracts might be held until expiration for traders who want to
buy or sell the underlying. But most futures traders are speculating on the price of the
underlying, hoping to make a profit from favorable price movements without taking or
making delivery.

2. Source of contract: A forward contract is a customized contract, privately traded directly

between two identified counterparties. This is called over-the-counter trading and doesn’t
involve a futures exchange. In contrast, futures contracts are only available on futures
exchanges. You must set up a futures brokerage account to buy and sell these contracts.
A futures trader does not directly transact with a counterparty; instead, a futures clearing
house mediates all transactions – it acts as the buyer to sellers and the seller to buyers.

3. Contract terms: A forward contract is completely customized according to the wishes of

the buyer and seller. In addition, forward contracts have no built-in default protection,
though a custom default-protection scheme can be negotiated and included. Futures
contracts are highly standardized and guaranteed against default. Their expiration date,
delivery date, delivery point, amount of underlying asset and settlement terms cannot be
negotiated – the only decisions open to a trader are how much to bid or ask, when to
close out the position and to select financial or physical settlement, the contract
expiration month and the number of contracts.

4. Settlement procedures: Forwards are settled at expiration and perhaps more frequently
if both participants agree – there is no automatic daily cash settlement. Futures are cash-
settled every trading day.

5. Margin requirements: Forward contracts typically have few margin requirements, if

any. Futures exchanges require traders to deposit into their brokerage accounts a
minimum amount of cash per contract, as margin. The deposit is used to guarantee the
daily mark to market payment. If the account balance falls below the minimum
requirement, then the trader’s broker will issue a margin call – a directive to the trader to
replenish the account. Failure to do so promptly will lead to a forced offset – the broker
closes out the trader’s contracts and adds the cash proceeds to the brokerage account.