Forwards vs Futures

Forwards and futures both lock in a price today for a transaction in the future. The difference lies in how they are made and managed. A forward is a private, customised agreement between two parties, usually a company and a bank. A futures contract is a standardised product traded on an exchange and guaranteed by a clearing house. The economics are similar, but the practical differences in flexibility, risk and cash flows are large.

Side by side#

See OTC Markets and Clearing Houses and Central Counterparties.

How a forward works#

Why futures settle daily#

Daily mark to market means losses are paid every day rather than piling up until maturity. That keeps each trader's potential default small and lets the clearing house guarantee contracts. With a forward, a party sitting on a large loss at maturity might fail to pay, which is counterparty risk. See Market, Credit and Counterparty Risk and Mark-to-Market.

Cash flow differences#

Because of daily settlement, a futures position generates cash flows along the way, while a forward pays only at the end. If interest rates are correlated with the underlying's price, this can make futures and forward prices differ slightly: when the asset tends to rise as rates rise, futures holders reinvest gains at higher rates, making futures slightly more valuable. For most practical purposes, and for short maturities, the two prices are very close.

Pricing#

Both are priced from the cost of carry:

forward price = spot price × e^((r + storage - income) × T)

Where r is the financing rate, storage covers physical costs and income covers dividends or interest earned on the asset. See Spot vs Futures and Cash-and-Carry Arbitrage.

When to use each#

Non deliverable forwards#

For currencies with capital controls, such as some emerging market currencies, forwards may be settled in dollars based on the difference between the forward rate and a fixing rate, without exchanging the restricted currency. These are non deliverable forwards. See Non-Deliverable Forwards (NDFs).

Regulation after 2008#

After the 2008 financial crisis, regulators pushed many standardised over the counter derivatives into central clearing and required margin on uncleared trades, narrowing some differences between forwards, swaps and futures. See The 2008 Financial Crisis.

Frequently asked questions#

What is the difference between a forward and a futures contract?#

A forward is a private, customised agreement settled at maturity; a future is a standardised exchange traded contract, guaranteed by a clearing house and settled daily.

Which is riskier, forwards or futures?#

Forwards carry more counterparty risk because there is no clearing house guarantee, while futures carry the risk of margin calls from daily settlement.

Why do companies use forwards instead of futures?#

Because forwards can match exact amounts and dates of business transactions, which standardised futures may not.

Next, compare futures with owning stocks in Stocks vs Futures.