A Comparison Between Future and Forward Markets
As a common trend and general preference, it is most unlikely that the investors would ever involve in the forward market, it is important to understand some of the attitudes, particularly as a good deal of the literature on pricing futures contracts typically refers to those contracts interchangeably. Specially differences resulting from liquidity, credit risk, margin, taxes and commissions could cause futures and forward contracts not to be priced identically. For example, in dealing with price risk, futures contracts have several advantages of transaction in comparison to forward contracts. Sequential spot contracts, which is also known as spot contracts where the terms of the contract are re negotiated as events unfold, do not inject any certainty into the transaction. Such a method of contracting is particularly liable to the hazards of opportunism and may deter investment because of the relatively high probability that the contract will be breached. But the forward and futures contracts inject some certainty into their transaction. In both of these, there is a similarity that the parties agree to perform the terms of the contract at some future date. Time dated contracts are generally costlier to enforce than spot contracts. This is so because of the absence of the self enforcing exchange of value characteristic of spot transactions and the greater uncertainty attached both to the eventual outcome and each party’s compliance with the term of forward contract. There are some differences between futures and forward contracts. The difference is more susceptible to opportunism, especially in their role of reducing price risk. Forward contracts that cover all feasible contingencies are costly specified forward contract and this contractual incompleteness will give rise to enforcement and execution difficulties. Some of the difficulties are listed below:
- Individuals will have to incur the expense of determining the reliability risk of the opposite party in the forward contract.
- Forward contracts are also subject to high enforcement costs where personal markets are weak.
- Forward contracts are tied contracts.
Special Features of Future and Forward Markets
Future Market Features
- Trading is conducted in a competitive arena by “open country” of bids, offers, and amount.
- Contract terms are standardized with all buyers and sellers negotiating only with respect to price.
- Non-member participants deal through brokers.
- Participants include banks, corporations, financial institutions, individual investors are speculators.
- The clearing house of the exchange becomes the opposite side to each cleared transactions; therefore, the credit risk for a futures market participant is always the same and there is no need to analyze the credit of other market participation’s.
- Margins deposits are to be required of all participants
- Settlements are made daily through the exchange clearing house. Gains on open positions may be withdrawn and losses are collected daily.
- Long and short positions are usually liquidated easily.
- Settlements are normally made in cash, with only a small percentage of all contracts resulting actual delivery.
- A single, round tip (in and out of the market) commission is charged. It is negotiated between broker and customer and is relatively small in relation to the value of the contract.
Forward Market Features
- Trading is done by telex or telephone, with participants generally dealing directly with broker-dealers.
- All contract terms are negotiated privately by the parties.
- Participants deal typically on a principal -to-principal basis.
- Participants are primarily institutions dealing with one other and other interested parties dealing through one or more dealers.
- A participant must examine the credit risk and establish credit limits for each opposite party.
- Typically, no money changes hands until delivery, although a small margin deposit might be required of non dealer customers on certain occasions.
- Settlement occurs on date agreed upon between the parties to each transaction.
- Forward positions are not as easily offset or transferred to other participants.
- Most transactions result in delivery.
- No commissions is typically charged if the transaction is made directly with another dealer. A commission is charged to both buyer and seller, however, if transacted through a broker.
- Trading is mostly unregulated.
- The delivery price is the forward price.