What are the basic differences between the operation of a currency forward market and a futures market?
A forward contract is a private and customizable agreement that settles at the end of the agreement and is traded over the counter (OTC). A futures contract has standardized terms and is traded on an exchange, where prices are settled on a daily basis until the end of the contract.
Currency forwards and futures are very similar. The main difference is that currency futures have standardized terms and are traded on exchanges such as the Chicago Mercantile Exchange (CME), whereas forwards have customizable terms and are traded over-the-counter (OTC).
One of the main differences between the two is that the forward contract is an over-the-counter agreement between two parties, i.e., a private transaction. On the other hand, futures contracts trade on a highly regulated exchange, according to standardized features and terms of the contract.
They both entail an agreement between two parties to buy or sell an asset on a specific date in the future, at the terms decided today. The only difference is that forwards are over the counter (OTC) contracts while futures are exchange traded contracts and hence standardized and also more secure.
The main difference between futures and options trading is that futures are a contract that obligates the buyer to purchase or sell an asset at a specified future date and price, while options give the buyer the right, but not the obligation, to purchase or sell an asset at a specified price and date.
| Futures | Forwards |
|---|---|
| Settled Daily | Settled at Maturity |
| Standardized | Not Standardized |
| Low risk of not fulfilling obligations, due to regulation and oversight | Low level of regulation and oversight on settlement |
| Traded on Public Exchanges | Private contract between two parties |
In cash market you can buy shares and hold for life. In futures, you have to settle the contract on the expiration date i.e. maximum of three month. When you are shareholder of the company, you are entitled to receive dividend. In future contract you are not entitle for any dividend.
The Forward contracts include a high counter party risk and there is also no guarantee of asset settlement till the maturity date. The Futures contract involves a low counterparty risk and the value is based on the market rates and is settled daily with profit and loss.
A forward contract is a private and customizable agreement that settles at the end of the agreement and is traded over-the-counter. A futures contract has standardized terms and is traded on an exchange, where prices are settled on a daily basis until the end of the contract.
Forward contracts do not trade on a centralized exchange and are therefore regarded as over-the-counter (OTC) instruments. While their OTC nature makes it easier to customize terms, the lack of a centralized clearinghouse also gives rise to a higher degree of default risk.
What are the limitations of the forward market?
Their use is limited by three major problems with forward contracts: (1) it is often costly/difficult to find a willing counterparty; (2) the market for forwards is illiquid due to their idiosyncratic nature so they are not easily sold to other parties if desired; (3) one party usually has an incentive to break the ...
Futures prices can differ from forward prices because of the effect of interest rates on the interim cash flows from the daily settlement. If interest rates are constant, or have zero correlation with futures prices, then forwards and futures prices will be the same.
An option gives the buyer the right, but not the obligation, to buy (or sell) an asset at a specific price at any time during the life of the contract. A futures contract obligates the buyer to purchase a specific asset, and the seller to sell and deliver that asset, at a specific future date.
Difference between futures and options
Futures are a contract that the holder the right to buy or sell a certain asset at a specific price on a specified future date. Options give the right, but not the obligation, to buy or sell a certain asset at a specific price on a specified date.
The Bottom Line. While the advantages of options over futures are well-documented, the advantages of futures over options include their suitability for trading certain investments, fixed upfront trading costs, lack of time decay, liquidity, and easier pricing model.
The Forward contracts can be customized as per the needs of the customer. There is no initial payment required and this is mostly used for the process of hedging. The Futures contracts on the other hand are standardized and traders need to pay a margin payment initially.
The key difference between a forward and a futures contract is: a forward contract is customized where a futures contract is not. The clearing corporation's main role in the futures market is to: act as the counterparty to both sides of the transaction, thereby guaranteeing payment.
Currency futures are futures contracts for currencies that specify the price of exchanging one currency for another at a future date. The rate for currency futures contracts is derived from spot rates of the currency pair. Currency futures are used to hedge the risk of receiving payments in a foreign currency.
Instead of buying in the cash market, if the trader decides to buy it in the futures market and hold the balance money in a mix of liquid funds and debt funds, then he would still be better off by nearly 500 basis points. That is the advantage of using futures as a long term investment tool.
Basis can be defined as the difference between the clean price of the cash security minus the converted futures price. For example, consider a cash 5-year note, the 1.75% of November 30, 2021 versus the March 2017 5-year U.S. Treasury futures contract (FVH7).
Why futures are better than cash?
In a cash market, the full amount for the shares must be paid in cash, while in a futures market, only margin money is needed.In a cash market, an investor cannot short sell shares, but in a futures market, both long and short positions can be taken.
Future contracts have numerous advantages and disadvantages. The most prevalent benefits include simple pricing, high liquidity, and risk hedging. The primary disadvantages are having no influence over future events, price swings, and the possibility of asset price declines as the expiration date approaches.
Advantages and Disadvantages of Forward Exchange Contracts
The certainty provided by the contract helps a company project cash flow and other aspects of business planning. The disadvantage of the forward contract is that neither party can profit from a significant currency exchange rate shift in their favor.
A forward market is an over-the-counter (OTC) marketplace for foreign exchanges, securities, interest rates, and commodities, unlike the stock, derivatives, or commodity markets. The term forward market is most commonly associated with the currency market.
There are many advantages and disadvantages of future contracts. The most common advantages include easy pricing, high liquidity, and risk hedging. The major disadvantages include no control over future events, price fluctuations, and the potential reduction in asset prices as the expiration date approaches.
