Future and Forwards contracts are used by businesses and investors to hedge against risks or speculate. Both Futures and Forward are similar in many ways like both involve the agreement to buy and sell assets at a future date and both have prices that are derived from some underlying asset.
A forward contract is an obligation to buy or sell a certain asset:
- At a specified price (forward price)
- At a specified time (contract maturity or expiration date)
- Typically not traded on exchanges
Futures are the same as forward contracts, except for two main differences:
- Futures are settled daily (not just at maturity), meaning that futures can be bought or sold at any time.
- Futures are typically traded on a standardized exchange.
Note : A forward contract is a private and customizable contract that settles at the end of the contract and is traded over-the-counter(OTC). A futures contract has standardized terms and is traded on an exchange, where prices are settled on a daily basis until the end of the contract.
|Settled on daily basis||Settled at Maturity or expiration date|
|Standardized agreement||Not Standardized agreement|
|Low risk of not fulfilling obligations, due to regulation and oversight||High counterparty risk of not fulfilling obligations, due to low level of regulation and oversight|
|Traded on Exchanges.||Traded on over the counter(OTC)|
Futures are traded on an exchange and they have clearing houses that guarantee the transactions.
What Is Counterparty Risk?
Counterparty risk is the probability that one of those involved in a transaction might default on its contractual obligation. Counterparty risk can exist in credit, investment, and trading transactions.
If one party has a higher risk of default, a premium is usually attached to the transaction to compensate the other party. The premium added due to counterparty risk is called a risk premium. In retail and commercial financial transactions credit reports(credit score) are often used by creditors to determine the counterparty’s credit risk.
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