The derivative market is gaining huge popularity over the years among traders in the Indian stock markets. While a lot has been said about option trading, the other segments of derivative trading are forward contracts and future contracts. But are you among the novice traders who think they are not much different? If yes, check out this blog to understand the basic meaning of these terms and the core differences between the two.
Read More: What are futures and options?
What is a derivative market?
Let us begin with the most basic question which is the meaning of derivative market. A derivative market is a financial marketplace where traders buy or sell contracts derived from underlying assets like stocks, bonds, commodities, or indices. These contracts, known as derivatives, derive their value from the price movements of these underlying assets. Traders use derivatives to speculate on price changes, hedge against risks, and manage investment exposure. The segments of the derivative market in India include futures and options, forward contracts, and swaps.
What is a forward contract?
A forward contract is a financial agreement between two parties to buy or sell an asset, such as a commodity, currency, or financial instrument, at a pre-determined price on a specific future date. The highlight of a forward contract is that this contract is binding, and both parties are obligated to fulfill their respective sides of the agreement, regardless of market conditions at the time of contract maturity.
Forward contracts are not traded on public exchanges like futures contracts. They are private agreements and can be customized to suit your specific trading requirements. While they offer protection against price fluctuations, they also come with the risk of potential counterparty default. Therefore, some traders prefer using standardized derivatives like futures contracts, which are traded on exchanges and offer more liquidity and transparency.
What is a futures contract?
A futures contract like a forward contract is part of the derivative market but is more standardised as compared to a forward contract. It is a financial agreement to buy or sell an asset at a predetermined price on a specific future date. This contract is traded on organized exchanges, creating a regulated marketplace for various assets like commodities, currencies, stock indices, and interest rates thereby providing more transparency and liquidity. Futures contracts are standardized agreements traded on established exchanges, such as the NSE and MCX in India. They involve a long party committing to buy an asset and a short party agreeing to sell, with set quantities, prices, and delivery dates. Traders have to provide an initial margin for buying futures and use the leverage to control larger position sizes with limited capital.
What are the different types of future contracts?
The four types of future contracts are commodity futures, currency futures, stocks and index futures, interest rate futures, VIX futures, etc.
What are the differences between a forward contract and a futures contract?
Some of the key points of difference between a forward contract and futures contract are tabled below.
| Category | Forward Contract | Futures Contract |
| Meaning | A forward contract is a private agreement between two parties to buy or sell an underlying asset | A futures contract is a standardized contract to buy and sell an asset on a future date at a fixed price. |
| Standardization | Forward contracts are often customized to suit the parties’ needs | Futures contracts have standardized terms for consistency and pre-defined lot sizes. |
| Liquidity and Transparency | Forward contracts lack transparency and liquidity, being private agreements. | Futures contracts are highly liquid and traded on exchanges, providing transparency. |
| Regulations | Forward contracts are over-the-counter contracts and therefore have minimum to no regulation. | Futures contracts are strictly regulated by exchanges and relevant authorities. |
| Risk | Forward contracts have higher counterparty risk. | Future contracts have lower counterparty risks |
| Settlement | Forward contracts are settled at the maturity date and are settled in cash or physical settlement | Future contracts are settled on a daily basis and are settled in cash as the difference between the spot price and the futures price. |
| Margin | A forward contract has no collateral requirement, as the parties trust each other to honour the contract. | A futures contract has a collateral requirement, as the parties have to deposit an initial margin and maintain a maintenance margin to cover potential losses. |
| Costs | Forward contracts usually have lower transaction costs. | Futures contracts may involve brokerage, exchange fees, and margin requirements. |
| Price determination | Forward contract prices are mutually agreed upon between the parties to the contract. | Futures contract prices are determined by open market forces. |
Conclusion
A futures contract is a far more standardized and low-risk derivative instrument as compared to a forward contract. This makes it more popular among traders and also approachable for new traders in the stock markets. However, it is important for traders to understand the risks and all the key aspects of these contracts for creating a successful trading portfolio.
