For all practical purposes, when a forward contract is standardized and dealt in an organized exchange, it becomes a future contract. Basically, they both seem to be one and the same.However, they differ from each other in the following respects:
Nature of the Contract: A forward contract is not at all a standardized one. It tailor made contract in the sense that the terms of the contract like quantity,price,period,date,delivery conditions etc. can be negotiated between the parties according to their convenience. On the other hand, a futures contract is a highly standardized and they can not be altered to the requirements of the parties to the contract.
Existence of Secondary Market: Since forward Contract is a customized contract, it is not a standard one. So, it cannot be traded on an organized exchange. With a result, there is no secondary market for a forward contract. But, futures contract can be traded on organized exchanges. Hence, it has a secondary market.
Settlement: A forward contract is always settled only on the date of maturity. But, Future contract is always settled daily, irrespective of the maturity date, in the sense that, it is ‘market to markets’ on a daily basis.
Modus Operandi: Generally, parties enter into forward agreement with the help of some financial intermediary like a bank. But, it is not so in the case of a futures contract. It is mainly facilitated through organized exchanges and the question of a third party does not arise.
Down Payment: In the case of forward contract, the contracting parties need not pay any down payment at the time of agreement. However, in the cases of a futures contract, the contracting parties have to deposit a certain percentage of the contract price as a ‘Margin Money’ with the exchange. it acts as a collateral to support the contract.
Delivery of the Asset: The delivery of the assets in question is essential on the date of maturity of the contract in the case of a forward contract whereas a futures contract does not end with the delivery of the asset. The parties merely exchange the difference between the future and spot prices on the date of maturity.
One can derive the following advantages from a forward as well as futures contract:
- Protection against Price Fluctuations: Parties to these contracts can protect themselves against the risk of adverse fluctuations in the price of assets in question. For instance, the buyer of a forward rate currency contract can avoid risk of a possible adverse hike in the exchange rate in future. Similarly, the buyer of a commodity future contract can avoid the risk of a possible price escalation in future. Thus, risks can be overcome.
- Avoidance of Carrying Costs: The buyer of this contract can avoid paying carrying costs on the asset bought in advance since he need not take delivery of the asset in advance of the time it is required.
- Proper Planning for Buying / Selling: These contracts enable the parties to buy or sell assets at the time when they are most required and thus they prevent the need to purchase or sell assets in advance of future requirements. Thus, they facilitate proper planning for buying and selling.
- Proper Portfolio Management: Portfolio managers, investors or even speculators can use these contracts to hedge against future declines in portfolios or against adverse future fluctuations in prices. Thus, they act as a boon to portfolio management.
- Proper Cash Management: These contracts avoid the payment of the purchase price immediately. In the absence of these contracts, liquid cash must have been paid at the time of the contract itself. Now, the purchaser can make use of this fund to earn further income till the maturity of the contract. Thus, efficient cash management is made possible with help of these contracts.
- Purchase and sales in bulk: These contracts facilitate bulk purchases and sales of assets at short notice in advance of delivery and even in advance of production.
- Highly Flexible: These contracts are highly flexible and if the parties to the contract prefer to close out their positions, they can do so by exchanging the net difference between the positions. They need not take the trouble of exchanging the assets physically.
- Boon to Financial Intermediaries: These contracts give a very good scope for the financial companies to play a dynamic role. They can act as intermediaries between the parties. They can diversify their activities by innovating new instruments in this field and taking up new lines of financial activities in the best interest of their customers.