Derivatives are financial instruments that traders employ to manage risk or predict price movements in various markets. Futures and forwards contracts are among the most commonly used derivatives.
Anyone interested in discovering more about derivatives trading must first understand the key differences between these two contracts.
Let us explore the basics of futures vs forwards contracts, including their features and differences.
What is Derivatives Trading?
Financial contracts known as derivatives derive their value from the performance of an underlying asset, which can include stocks, bonds, commodities, or currencies.
With these contracts, traders can hedge against market volatility or speculate on future price swings. In general, there are two ways to trade derivatives: over-the-counter (OTC) and through an exchange.
OTC derivatives are private agreements between parties, whereas exchange-traded derivatives are standardised and regulated.
What is a Futures Contract?
A legally binding agreement between two parties to buy or sell an asset at a set price on a future date is known as a futures contract. These contracts are traded on regulated exchanges, which ensures transparency and standardisation.
Futures contracts have predetermined terms and conditions, including trade volume, delivery schedule, and credit processes.
One of the most significant features of futures contracts is that they are highly leveraged. This implies that to initiate the trade, you only need to deposit a small amount, referred to as the margin, of the total contract value. While profits may rise as a result, there is also a greater chance of losses.
What is a Forward Contract?
Unlike futures, a forward contract is a private agreement between two parties to buy or sell an asset at a specified price on a set future date.
These contracts are not standardised and are typically traded over-the-counter (OTC). This means that the terms of forward contracts can be customised to meet the specific needs of the parties involved, such as the amount of the asset, the price, and the delivery date.
Forward contracts carry more risk than futures because they are not regulated by an exchange. There is no formal intermediary, so there’s a risk that one party might default on the agreement.
This makes forward contracts prone to counterparty and default risks. Moreover, forward contracts often lack the transparency and pricing efficiency that futures contracts offer.
Key Differences: Futures vs Forwards
When comparing futures vs forwards, it’s essential to understand their major differences:
Regulation:
- Futures contracts are regulated by market authorities, such as the Securities and Exchange Board of India (SEBI), ensuring safety and standardisation.
- Forward contracts are self-regulated, and the terms are privately negotiated.
Collateral:
- Futures contracts require an initial margin to be deposited, which acts as collateral and minimises risks.
- Forward contracts do not require margins, as they are based on trust between the two parties.
Settlement:
- Futures contracts are marked-to-market daily, which means that their positions are settled at the end of each trading day.
- Forward contracts are settled only on the contract’s maturity date, according to the negotiated terms.
Risk:
- Futures contracts are considered less risky since they are regulated by exchanges that guarantee the trade. Additionally, there is no risk of default or counterparty issues.
- Forward contracts are riskier due to the possibility of one party defaulting, and the lack of an intermediary means these contracts aren’t subject to daily settlement procedures.
Understanding the PCR Ratio Formula
In both futures and forwards markets, understanding market sentiment can be crucial for traders. One popular tool used is the PCR ratio formula. This ratio is calculated by dividing the number of put options traded by the number of call options traded over a specific period. It is often used to determine if the market is bullish or bearish.
A high PCR ratio indicates that more put options are being traded, which could mean traders expect the market to decline.
On the other hand, a low PCR ratio suggests more call options, pointing to bullish market sentiment. Whether you’re dealing with futures vs forwards, knowing how to read the PCR ratio formula can help you make informed decisions.
Conclusion
Both futures and forwards contracts serve as useful tools for managing risk and taking advantage of market movements. The major difference between futures vs forwards lies in their structure, regulation, and risk exposure.
Futures contracts offer standardisation, greater liquidity, and less risk due to the involvement of exchanges. Meanwhile, forward contracts provide flexibility but come with higher risks due to the lack of regulation.
Frequently Asked Questions
1. What is the difference between futures and forward contracts?
Futures contracts are standardized agreements traded on exchanges, whereas forward contracts are customizable and traded over-the-counter (OTC).
2. How do futures contracts work?
Futures contracts involve agreeing to buy or sell an asset at a predetermined price on a specific future date. These contracts are settled through exchanges.
3. How do forward contracts work?
Forward contracts are private agreements between two parties to buy or sell an asset at a specified price on a future date, without the involvement of an exchange.
4. Are futures contracts safer than forward contracts?
Futures are generally considered safer due to their standardized nature, daily settlement process, and clearinghouse involvement, which reduces counterparty risk. Forwards, however, carry more counterparty risk as they are private agreements.
5. Can forward contracts be traded on exchanges?
No, forward contracts are customized and traded over-the-counter, meaning they are not available on exchanges.
6. What assets are typically traded using futures contracts?
Futures contracts can be traded on a wide range of assets, including commodities (like gold, oil, and wheat), currencies, indices, and even financial instruments such as bonds and interest rates.
