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On the financial market there exist many different kinds of derivatives, some more complex than others. Two of these derivatives are future and forward contracts. They are both instruments that can be used to hedge a position in the future and is often used as a tool to speculate in various markets. At a glance these two derivatives can easily be seen as one of the same but there are differences.

A forward contract is an agreement between a buyer and a seller where they at the trading date decides to buy and sell an underlying asset for a specific price in the future. These derivatives methods are used to control and hedge risks in the future. It could be the price of a produce or a financial asset or even an interest rate.

The buyer agrees to purchase the asset for a price in the future and the seller simultaneously agrees to sell the product for that price. No money is swapped at the trading date so the forward contract is settled at the delivery date. If the price has increase when it's time to settle the contract, the buyer has made a good deal and the other way around.

A future contract is a forward contract which is traded on the future exchange. A future is a standardized contract in where the settlement type, date and price are mentioned. The clearinghouse then acts as a counterpart on all future contracts and set margins etc.

Another difference between a forward and a future is that a forward is only transacted on the trading date and the delivery date whereas the future is marked-to-market everyday. This rebalancing of the price leads to a less credit risk for the parties.

This is how the rebalancing works; a buyer and seller of 1 barrel of apples have decided to sign a future where the settlement price is 100 $. On the second day of the contract the market price of the underlying asset i.e. the barrel of apples costs 98$. The mark-to-market would then require that the seller gives the buyer 2$. The money goes via the exchange to the buyer and this rebalancing takes place everyday.

If this had been a forward contract, no rebalancing would have taken place and one party will have to fork up the difference between the market price and the settlement price on the settlement day. As the difference between the two prices can be substantial, these contracts have far greater credit risk than the futures.

Learn more about this author, Camilla Persson.
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