Similarities Between Forward and Futures Contracts

Similarities Between Forward and Futures Contracts

Anticipation type contracts used in the business world for a purchase commitment.

Futures and forwards are both anticipation type contracts used in the business world for a purchase commitment. The intention of this article is to review the similarities of the two contract types. Before doing so, however, it is important to understand the underlying concepts of both.

What is a Futures Contract?

A futures contract is a commitment to an exchange by a buyer and a seller. Both parties agree on the exchange of a commodity at a set price and on a set date in the future. When this date arrives, regardless of the current market value of the commodity, the exchange must take place at the agreed price point. This type of contract meets certain standards to allow for trading on a futures exchange. This standardization is aimed at promoting liquidity and so standards are typically set for areas such as the quality expected, and the quantity expected.

Of course, establishing an obligatory transactional contract is a projection-based discipline. Both buyers and sellers aim to make a profit from same. Typically, buyers have an inclination of a potential price increase. This leads them to attempt to ensure that they can access the commodity for a lower price if that price increase occurs. Similarly, sellers forecast a drop in the value of the commodity and to maximize returns, they attempt to use futures to lock in prices so they can sell at a higher price, should a value dip occur. Of course, these predictions are not always accurate and both parties stand a chance of realizing a loss from the contract.

What is a Forward Contract?

A forward contract is a commitment to an exchange by both a buyer and a seller. Both parties agree on the exchange of an asset for a set price on a set date. Upon arrival of the date set in the contract, both parties are obligated to fulfill the contract at the price that was agreed on. These contracts are customized by the two parties and do not follow a set standard. As a matter of fact, the contracts can be completely centered around the commodity being traded. Trading of forwards does not take place on an exchange and, therefore, they are Over the Counter (OTC) instruments.

Of course, the lack of standardization translates to a higher default risk for those entering into these contracts. Forwards are generally used to protect against volatile price shifts.

How Are These Contracts Similar?

With the definitions out of the way, the focus can exclusively be placed on the ways in which the two contract types are similar. These are:

  • Commitment to purchase – Both contracts require the buyer and the seller to commit to completing a transaction at a price by a specific date. In both cases, an obligation is set for both parties.
  • Predictive techniques – Both types of contracts are used as predictive techniques to ensure that a price is locked in. Consumers enter into these contracts to protect themselves from a projected price increase, while providers enter into these contracts to protect themselves from a projected price decrease.
  • Risk involved – Though the level of counterparty risk differs between the two contracts, both have such a risk involved in using them.
  • Regulation – Both contract types have applicable policies to their use. The policies used in futures come from a central regulatory authority while forwards take their policies from provisions in contract law.

Conclusion

Forwards and futures are both available as methods of agreeing on the exchange terms of an asset on a prior date to the actual exchange. While there are subtle differences between the two contract types, there also share quite a few similarities as well.

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