While futures and forward contracts are both a contract to deliver a commodity on a future date at a pre-arraigned price, they are different in several respects:
• Forwards only transact when purchased and on the settlement date. Futures, on the other hand, are rebalanced, or "marked-to-market", everyday to the daily spot price of a forward with the same agreed-upon delivery price and underlying asset.
o The lack of rebalancing of forwards means that, in some cases, due to movements in the underlying's price, a large differential will build up between the forward's delivery price and the settlement price.
This means that one party will incur a big loss at the time of delivery (assuming they must transact at the underlying's spot price to facilitate receipt/delivery).
This in turn creates a credit risk. More generally, the risk of a forward contract is that the supplier will be unable to deliver the required commodity, or that the buyer will be unable to pay for it on the delivery day.
o The rebalancing of futures eliminates this credit risk by forcing the holders to update daily to the price of an equivalent forward purchased that day. The cost of the forward will, by definition, converge, to the delivery price at the settlement date. This means that there will be very little additional money due on the final day to settle the future.
o Example for a future with a $100 futures price: Let's say that on day 50, a forward with a $100 delivery price (on the same underlying asset as the future) costs $88. On day 51, that forward costs, say, $90. This means that the mark-to-market would require the holder of one side of the future to pay $2 on day 51 to track the changes of the forward price. This money goes, via margin accounts, to the holder of the other side of the future. (A forward-holder, however, would pay nothing until settlement on the final day, potentially building-up a large balance. So, except for tiny effects of convexity bias or possible allowance for credit risk, futures and forwards with equal delivery prices result in the same total loss or gain, but holders of futures experience that loss/gain in daily increments which track the forward's daily price changes, while the forward's spot price converges to the settlement price.)
• Futures are always traded on an exchange, whereas forwards always trade over-the-counter, or can simply be a signed contract between two parties.
• Futures are highly standardised, whereas some forwards are unique.
• In the case of physical delivery, the forward contract specifies to whom to make the delivery. The counterparty for delivery on a futures contract is chosen by the clearinghouse.
• Forwards only transact when purchased and on the settlement date. Futures, on the other hand, are rebalanced, or "marked-to-market", everyday to the daily spot price of a forward with the same agreed-upon delivery price and underlying asset.
o The lack of rebalancing of forwards means that, in some cases, due to movements in the underlying's price, a large differential will build up between the forward's delivery price and the settlement price.
This means that one party will incur a big loss at the time of delivery (assuming they must transact at the underlying's spot price to facilitate receipt/delivery).
This in turn creates a credit risk. More generally, the risk of a forward contract is that the supplier will be unable to deliver the required commodity, or that the buyer will be unable to pay for it on the delivery day.
o The rebalancing of futures eliminates this credit risk by forcing the holders to update daily to the price of an equivalent forward purchased that day. The cost of the forward will, by definition, converge, to the delivery price at the settlement date. This means that there will be very little additional money due on the final day to settle the future.
o Example for a future with a $100 futures price: Let's say that on day 50, a forward with a $100 delivery price (on the same underlying asset as the future) costs $88. On day 51, that forward costs, say, $90. This means that the mark-to-market would require the holder of one side of the future to pay $2 on day 51 to track the changes of the forward price. This money goes, via margin accounts, to the holder of the other side of the future. (A forward-holder, however, would pay nothing until settlement on the final day, potentially building-up a large balance. So, except for tiny effects of convexity bias or possible allowance for credit risk, futures and forwards with equal delivery prices result in the same total loss or gain, but holders of futures experience that loss/gain in daily increments which track the forward's daily price changes, while the forward's spot price converges to the settlement price.)
• Futures are always traded on an exchange, whereas forwards always trade over-the-counter, or can simply be a signed contract between two parties.
• Futures are highly standardised, whereas some forwards are unique.
• In the case of physical delivery, the forward contract specifies to whom to make the delivery. The counterparty for delivery on a futures contract is chosen by the clearinghouse.