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Difference between Futures and Forward Contracts

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Picsjoin 2017224123730582 answered

Hie Roshni, **The fundamental difference between futures and forwards is that futures are traded on exchanges and forwards trade OTC. The difference in trading venues gives rise to notable differences in the two instruments :-** - Futures are standardized instruments transacted through brokerage firms that hold a "seat" on the exchange that trades that particular contract. The terms of a futures contract - including delivery places and dates, volume, technical specifications, and trading and credit procedures - are standardized for each type of contract. Like an ordinary stock trade, two parties will work through their respective brokers, to transact a futures trade. An investor can only trade in the futures contracts that are supported by each exchange. In contrast, forwards are entirely customized and all the terms of the contract are privately negotiated between parties. They can be keyed to almost any conceivable underlying asset or measure. The settlement date, notional amount of the contract and settlement form (cash or physical) are entirely up to the parties to the contract. - Forwards entail both market risk and credit risk. Those who engage in futures transactions assume exposure to default by the exchange's clearing house. For OTC derivatives, the exposure is to default by the counterparty who may fail to perform on a forward. The profit or loss on a forward contract is only realized at the time of settlement, so the credit exposure can keep increasing. - With futures, credit risk mitigation measures, such as regular mark-to-market and margining, are automatically required. The exchanges employ a system whereby counterparties exchange daily payments of profits or losses on the days they occur. Through these margin payments, a futures contract's market value is effectively reset to zero at the end of each trading day. This all but eliminates credit risk. - The daily cash flows associated with margining can skew futures prices, causing them to diverge from corresponding forward prices. - Futures are settled at the settlement price fixed on the last trading date of the contract (i.e. at the end). Forwards are settled at the forward price agreed on at the trade date (i.e. at the start).

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