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Futures and forward contracts are both agreements to buy or sell an asset at a certain price in the future. Although they are both investment vehicles of the exchange-traded markets, where individual trade standardized contracts defined by the exchange, they are also different in numerous ways.

A futures contract is a standardized contract that is traded on a futures exchange. The owner of a futures contract can buy or sell the underlying asset, which can be a commodity, stock, or bond, at certain future date (delivery date) at a certain price (settlement price). In effect, the delivery date is a range of delivery dates, the contract is settled daily and the position is closed prior to maturity. Because of the daily settlement, a futures contract bears virtually no credit risk as the risk is spread over the daily cash flows until maturity.

A forward contract is a non-standardized contract that is traded in the over-the-counter market. It is a private contract between two parties that is not subject to any standard contract size or delivery arrangements. The owner of a forward contract can buy or sell the underlying asset at certain future date (delivery date) at a certain price (settlement price). The delivery date is one specified date, the contract is typically settled on maturity, and it is almost always delivered. Because it is settled on maturity, a forward contract bears some credit risk as the risk is accumulated until maturity.

To illustrate how futures contracts are different than forward contracts we assume that the exchange rate of the British pound for a 90-day future contract and a 90-day forward contract is 1.6000 USD per GBP. Investor A is long (has bought) 100,000 GBP in a 90-day futures contract and investor B is long (has bought) 100,000 GBP in a 90-day forward contract. Although the settlement price and the delivery date are the same, there are difference between the gains and losses under the two contracts. In particular:

As already explained, under the futures contract, the gains or losses are realized day by day because of the daily settlement; under the forward contract, the gains or losses are realized on maturity. Therefore, assuming that the spot exchange rate in 90 days rises to 1.8000 USD per GBP, investor A will make a gain of $20,000 spread out over the 90-day period, while investor B will make the same gain but on maturity, that is on the 90th day. Similarly, investors may realize losses, but investor A, who has the futures contract, will make a gain of $20,000 over the 90-day period regardless if on several days there are losses.

Both futures and forward contract trade actively on foreign currencies. However, their prices in the exchange markets are quoted differently. Futures prices are quoted as the number of US dollars per unit of the foreign currency. Forward prices are quoted as spot prices. Therefore, for the British pound, the Euro, the Australian dollar and the New Zealand dollar, the forward quotes are the number of US dollars per unit of the foreign currency and are directly comparable with futures quotes. For other major currencies, such as Japanese Yen or Canadian dollar, forward quotes are the number of units of the foreign currency per US dollar.

Learn more about this author, Christina Pomoni.
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