Forward Contract Vs. Future Contract

Putting it in simple legal terms, when two or more competent parties voluntarily and legally sign an agreement, which binds them together, it's called a contract. Sometimes, you as a seller or buyer, while selling or buying products, may have to sign an agreement or contract with the other party. These agreements maybe of two types; future and forward contracts. But several people who are new to this business, have no idea as to how the two contracts are different from each other. For these people, given below are some pointers on forward contract vs future contract. Before going into the differences, let us first see what a future and forward contract actually means.

What is a Forward Contract?

It is actually a private contract between the buyer and the seller. Here, the buyer agrees to buy and the seller agrees to sell a decided quantity of products or security, at a price which is mentioned in the contract. This decided product or security is also called underlying instrument. This contract differs from other contracts in a way that the delivery and payment of the agreed product or the underlying instrument does not take place immediately, but in the specified future date which is mentioned in the agreement.

Let me explain this to you with the help of an example. The year is 2010. You own a shoe company, let's say ABC Ltd. Mike, a shoemaker, agrees to sell you 1000 pair of shoes for $25, each pair, in the year 2011. This, he does, even before he starts making the shoes. The actual exchange of the shoes and money will only take place after Mike has made them. Thus, you have signed this contract with him. By doing this, both of you have protected yourself against the risks that might have affected you. Mike has protected himself against a decrease in price, than the agreed price, while on the other hand, you have protected yourself against the increase in price. Both of you have eliminated the risk of getting a bad price for your shoes. Now the shoes are ready to be sold. It might be that due to normal circumstances which affect the demand and supply, the price of the shoes might increase to say $30 a pair. This is when Mike wishes that he had not entered into the agreement of selling it for $25 a pair. Your company on the other hand will be pleased as you will get the $30 shoes for $25. but if the price falls to $20 a pair, then it's you will suffer a loss, as you have to buy shoes for $25 instead of $20. Therefore, if the contract price is higher than the current price, then Mike is happy. But you as a buyer will smile, if the contract price is lower than the market price.

To avoid any kind of problems in future, before signing a forward contract, as a seller or even as a buyer, make sure that all terms and conditions are clear to you and there are no confusions regarding delivery terms, locations, quality of the agreed products, credit terms, payment terms, etc. After making sure that there is absolutely no confusion, then sign the contract.

What is a Future Contract?

Another type of contract that can be signed between a seller and a buyer is the future contract. The concept behind future and forward contracts are the same. Like a forward contract, it is also a contract or an agreement for the sale or purchase of a good or loan, or currency at some time in the future. However, when it comes to forward contract vs future contract, the latter is a publicly traded contract, while the former is privately traded contract which takes place between people who know each other. These contracts trade on the floor of future exchange, as thus their transactions are managed by a broker, who is a members of that exchange. The party who has made the contract remains anonymous.

For e.g.: Your company ABC Ltd, decides to buy at least 20,000 pairs of shoes through this contract. You have no idea who is the actual seller, as the entire transaction is being managed by a middleman, or a broker. But what could be the disadvantage of this contract? It increases the chances of risk. But despite the risk involved in dealing with an anonymous party, people are still going in for this contract, because of the exchange that facilitates the transaction guarantees all trades. The exchanges are also backed by insurance policies, lines of credit and the financial background of the members who are involved in the transaction. Risk is also reduced by the members setting up strict rules regarding the contract and the counter parties. Customers who are buying and selling these contracts need to post a security deposit, which is called a margin. This, they have to post against their market positions. They also have to cover their losses regularly, which according to them is called 'marked to the market'.

Future Contract vs Forward Contract

Categories	Forward Contract	Future Contract
Structure	Usually no initial payment is required. This contract is customized to the needs of the customers.	Initial margin payment is needed. This contract is standardized to the needs of the customers.
Method of pre-termination	You have opposite contract with the same or different counter parties. However the risk while dealing with different counter party remains.	There is opposite contract on the exchange.
Size of the contract	Depends on how big the transaction is and what are the requirements of the transaction.	The size is standardized.
Risk involved	High risk involved.	Low risk involved.
Regulations in the market	They are not regulated.	They are a government regulated market.
Definition	Agreement between 2 or more parties to buy or sell a product, on a per-agreed date in the future.	Standardized contract, which is traded on a future exchange, in order to buy or sell a certain underlying instrument on a particular date in the future, at an agreed price.
Expiry date of the contract	Depends on the contract.	Expiry date is standardized.
Method of transaction	Direct negotiations between the buyer and the seller.	Transaction takes place on the Exchange.
Institutional guarantee	Contracting parties.	Clearing house.
Guarantees involved	No guarantees involved. Once the contract has been made, it is very difficult to undo it till the expiry date is over.	Both the buyer and the seller deposit a certain amount (deposit or margin), as an initial guarantee. Value of operations 'marked to market' rates, with the profit and losses being settled daily.

Now that you know the difference in a forward contract and future contract, it will be easier for you to sign a contract next time when you are buying or purchasing any product, or as it is called 'underlying instrument'.