Financial derivatives such as forwards and futures enable investors to hedge risk or earn potential returns by betting on the prices of underlying assets such as commodities, currencies, bonds and stocks. Forwards and futures are two types of derivatives.
Although forward and futures contracts sound alike in many respects, there are certain differences between futures and forwards that investors need to know. Continue reading to find out more.
Table of contents
- What is Futures contract?
- What is Forward contract?
- Futures vs forwards: Key differences
- Examples of forward contracts and futures contracts
- How do futures and forward contracts work?
- Advantages and disadvantages of forward and futures contracts
- When to use forward contracts vs futures contracts?
What is a futures contract?
A futures contract is a standardised derivative agreement traded on a recognised stock exchange in which two parties agree to buy or sell an underlying asset at a predetermined price on a specified future date. In India, futures contracts are traded on exchanges such as the National Stock Exchange (NSE) and BSE and are regulated by SEBI.
The underlying asset may include equity shares, stock indices, commodities, currencies, or interest rate instruments. The contract terms, such as lot size, expiry date, and settlement mechanism, are standardised by the exchange. Futures contracts are commonly used for hedging price risk or for trading based on market expectations.
What is a forward contract?
A forward contract is a customised derivative agreement between two parties to buy or sell an underlying asset at a predetermined price on a specified future date. Unlike futures contracts, forward contracts are privately negotiated and traded over-the-counter (OTC), rather than on a recognised stock exchange.
In India, forward contracts are commonly used in currency and commodity markets, particularly by businesses seeking to manage price or exchange rate risk. Certain forward transactions are governed by the Reserve Bank of India (RBI) and other applicable regulations, depending on the nature of the underlying asset. Forward contracts are generally used for hedging price exposure rather than retail trading.
Difference between futures and forwards
While both futures and forwards contracts involve an agreement to buy or sell an asset at a future date, there are some key distinctions between the two. Let’s look at the difference between futures and forwards.
| Metrics | Futures contract | Forwards contract |
|---|---|---|
| Trading platform | Traded on recognised stock exchanges such as NSE and BSE | Privately negotiated over-the-counter between two parties |
| Standardisation | Contract terms (quantity, expiry, lot size) are standardised by the exchange | Terms are customised as per mutual agreement between parties |
| Counterparty risk | Relatively lower due to clearing corporation guarantee | Higher, as settlement depends on the counterparty’s ability to honour the contract |
| Margin requirement | Initial and maintenance margins are mandatory | Margin terms depend on mutual agreement |
| Liquidity | Generally higher due to exchange trading | Liquidity depends on finding a willing counterparty |
| Mark-to-market | Settled daily through mark-to-market mechanism | Typically settled at contract maturity |
| Transparency | Prices are publicly quoted and transparent | Pricing is private between contracting parties |
Examples of forward contracts and futures contracts
Let’s look at some examples to understand how forward and futures contracts are used in practice.
- Gold futures contract: An investor buys 1 kg gold futures contract on MCX at Rs. 50,000 expiring in 1 month to speculate on rising gold prices. This gives the investor exposure to 1 kg physical gold without needing to pay the full value upfront. The contract is marked-to-market daily and gains and losses are settled based on gold price changes.
- Currency forward: An exporter enters into a 3-month USD/INR forward contract to sell $1 million at Rs. 80 per USD with a bank to hedge his foreign currency risk. This locks in an exchange rate helping protect against currency fluctuations.
- Commodity forward: A cotton farmer agrees to sell 20 quintals of cotton to a textile company in 6 months at Rs. 5,000 per quintal through a forward contract to hedge against price declines.
- Index futures: A fund manager buys Sensex futures contracts worth Rs. 5 crore to gain exposure to the equity market index performance with leverage. Gains and losses are settled daily based on index level changes.
How do futures and forward contracts work?
Both futures and forwards follow the same basic idea: they lock in a price today for something that will be exchanged later. But the way they operate day-to-day is quite different.
Agreement and price movement
Once the contract is in place, the market price of the asset will naturally move.
- In a forward contract, nothing is settled until the final date. The gain or loss is realised only at the end.
- In a futures contract, the profit or loss is settled every day through a process called mark-to-market.
Daily settlement in futures potentially helps mitigate counterparty risk, while forwards rely more on the creditworthiness of the parties involved.
Margin or collateral
- Futures require margins—these are deposits that have the potential to act as a financial buffer for the clearing system as prices move.
- Forwards may also involve collateral, but this depends on what the two parties decide. There is no standard margin process.
How settlement works
On the settlement date, the contract is completed either through:
- Physical delivery of the asset, or
- Cash settlement, where only the price difference is exchanged
Futures use whichever method the exchange specifies; forwards follow whatever the parties agreed upon at the start.
What are the main advantages and disadvantages of forward and futures contracts?
Forward and futures contracts may help manage price risk. However, they involve market, liquidity, margin, and counterparty risks. Outcomes remain uncertain, and losses may arise if prices move unfavourably. Here are the list of things to consider:
| Advantages | Disadvantages | |
|---|---|---|
| Forward contracts | Flexibility and customisation. Since forwards are privately negotiated, the parties may decide the exact quantity, settlement date, pricing structure, and other terms.They do not require daily mark-to-market settlement, which may suit participants who prefer a single settlement at maturity. | Higher counterparty risk, as performance depends on both parties fulfilling the agreement.Since forwards are not traded on an exchange, exiting, transferring, or offsetting the contract may be relatively difficult. Pricing transparency may also be limited. |
| Futures contracts | Standardisation and exchange supervision. As they are traded on regulated exchanges, pricing and settlement follow transparent rules.Daily mark-to-market accounting ensures gains and losses are adjusted regularly. Margin requirements and clearing corporation guarantees reduce counterparty risk. | Requirement of initial and maintenance margins. Daily mark-to-market settlement may result in frequent cash flow adjustments, increasing liquidity requirements.Standardised contract terms may not suit all hedging needs. |
When to use forwards vs futures?
The choice between a forward contract and a futures contract depends on a trader’s objectives, risk considerations, and the level of flexibility required.
A trader may prefer a forward contract when:
- A customised contract is required, including specific contract size, settlement date, or underlying asset.
- The transaction involves unique business requirements that may not match standardised exchange-traded contracts.
- The parties are comfortable entering into a privately negotiated agreement.
- Hedging needs relate to a specific exposure, such as a future foreign currency payment or receipt.
A trader may prefer a futures contract when:
- Standardised contracts are sufficient for the intended strategy.
- Greater liquidity is required, making it easier to enter or exit positions before expiry.
- The trader prefers the transparency of regulated exchanges.
- Lower counterparty risk is important, as exchanges use clearing corporations to facilitate settlement.
- Daily mark-to-market settlement is preferred for monitoring gains and losses throughout the contract period.
What is margin in futures contracts and how is it different for forward?
In a futures contract, margin is the upfront amount a trader deposits to enter a position. It is not the full contract value, but a percentage of it. This amount works like a security deposit and helps cover possible losses if prices move against the trader. In a forward contract, margin is not fixed by an exchange. Since forwards are private agreements, the two parties may decide whether any security deposit, advance payment, or collateral is needed. Here’s a more detailed look at the differences between the two:
| Criteria | Futures contract | Forward contract |
| Margin requirement | Requires an upfront margin deposit | Usually does not require standard margin |
| Trading platform | Traded on a recognised exchange | Privately agreed between two parties |
| Settlement | Gains and losses are adjusted daily | Usually settled on the final agreed date |
| Margin call | May apply if the margin balance falls | Usually not applicable unless agreed |
| Risk management | Managed through exchange and clearing house | Depends on the two parties involved |
| Flexibility | Standardised terms | Customised terms |
Conclusion
While forward and futures contracts are similar derivatives used for hedging, speculation and leveraging exposures, futures offer standardisation, liquidity and minimal counterparty risk as exchange-traded instruments. Forwards provide customised bilateral contracts for producers and consumers but with higher counterparty risk. Understanding these key differences allows investors to decide whether futures or forwards better match their investment needs and risk management preferences.
Also Read: Can mutual funds invest in futures and options? A detailed guide
FAQs:
What are the main features of forward contracts?
The key characteristics of forward contracts are term customisation such as contract size and settlement date, over-the-counter trading by private agreement, settlement upon maturity instead of on a daily basis, high counterparty default risk, and lower regulation than that of futures contracts.
What are the main features of futures contracts?
The key characteristics of futures contracts are standardisation of terms, trading on regulated exchanges to ensure liquidity, low counterparty risk from exchange-based clearinghouse, mark-to-market settlement of gains/losses every day, high leverage with small margin requirements, and strict controls by exchanges and regulators.
What are the risks of forward contracts?
Forward contracts involve counterparty risk, limited liquidity, and the possibility of adverse price movements at settlement. Since they are privately negotiated, there is no daily mark to market, which increases exposure if one party defaults. Their customised structure may also limit exit options before maturity, increasing overall contractual risk.
Can retail investors access futures?
Retail investors may access exchange-traded futures through registered intermediaries, subject to regulatory requirements and risk disclosures. Futures involve leverage, daily mark to market, and potential losses if markets move unfavourably. Investors may consider understanding contract specifications, risk limits, and margin needs before participating, as futures require disciplined risk management.
What assets can be traded using futures and forwards?
Futures and forwards are available on equity indices, individual stocks, currencies, interest rates, and commodities such as metals, energy, and agricultural products. Availability depends on exchange listings or bilateral arrangements. Each asset class carries its own risk profile, so understanding contract terms and market behaviour may support informed participation.
Are futures better than forwards?
Both serve different purposes and are structured differently. Futures are standardised contracts traded on recognised exchanges and regulated by the Securities and Exchange Board of India. Daily mark-to-market settlement and margin requirements reduce counterparty risk. In contrast, forwards are privately negotiated and carry higher default risk. Futures may also offer more liquidity and transparency. However, forwards allow greater flexibility, as contract terms be customised.
Which is more risky, futures or forward?
Forwards generally carry higher counterparty risk because they are over the counter contracts without exchange guarantees. Futures are cleared through recognised exchanges, which reduces default risk through margining and daily settlement. However, both involve market risk and leverage, and may not be suitable without proper risk assessment.
