by Janette Peel

Created on: September 20, 2007

The share market has a double that exists in future time even though it trades in the present. Futures and forward contracts are a long established and legal way to buy or sell a specified commodity at a fixed time in the future. Buying and selling are the most simplistic forms of trading in futures and forward markets. However, it is important to recognize what sets these two apart, and then by learning to combine futures and forward contracts with options, you can create trades that limit risk and maximize your potential profits. Let's have a look at their differences.

Fundamentally, futures and forward contracts have the same function until you look at the specific details of these contracts.

A forward contract is a non-standardized private agreement between two parties in which they agree to buy and sell a specific quantity of a certain security or commodity at a specific price. The delivery and payment of the asset occurs at a specified future date at the end of the contract, not immediately. An example of this is:

A cotton farmer has just planted a crop that is expected to yield 400 bales. To eliminate the risk of a fall in the price of cotton, the farmer executed a contract with a cotton gin/merchant whereby, the two parties agree on a specific price, for delivery on a future date when the crop is harvested. No money changes hands now. This will happen in five months time when the farmer delivers the 400 bales to the gin/merchant in exchange for the agreed cash. (Note the price is fixed and does not depend upon the spot price of cotton at the time of delivery and payment).

Because forward contracts are private agreements, there is always a chance that a party may default on its side of the agreement.

A futures contract is a standardized publicly traded contract for the purchase or sale of a loan, currency or commodity with an actual delivery scheduled to occur at some time in the future. Futures contracts trade on the floor of an exchange unlike forward contracts which trade over the counter. Clearing houses guarantee the transactions, which drastically lowers the probability of default to almost never.

As forward contracts settle at the end of the contract, futures contracts are marked-to-market daily, which means that daily changes are settled day by day until the end of the contract. Also, settlement for futures contracts can happen over a range of dates, whereas, forward contracts only possess one settlement date.

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