What is the difference between futures and forwards?

Forwards Contract:

A forward contract is the simplest of the Derivative products. It is a mutual agreement between two parties, in which the buyer agrees to buy a quantity of an asset at a specific price from the seller at a future date. The Price of the contract does not change before delivery. These type of contracts are binding, which means both the buyer and seller must stay committed to the contract. This means they are bound to deliver or take delivery of the product on which the forward contract was agreed upon. Forwards contracts are very useful in hedging.

Important Characteristics of Forwards Contracts:

1. They are Over the counter (OTC) contracts

2. Both the buyer and seller are bound by the contractual terms

3. The Price remains fixed

Limitations of Forwards contracts:

1. Lack of centralized trading. Any two individuals can enter into a forwards contract

2. Lack of Liquidity

3. Counterparty risk - The case wherein either the buyer or seller does not honour his end of the contract.

Futures Contract:

A futures contract is an agreement to buy or sell an asset at a certain time in the future at a specific price. The Contractual terms of the futures contracts are very clear. The Futures market was designed to solve the shortcomings in the forwards contracts. Unlike forwards, futures are traded in organized exchanges. They also use a clearing house that provides the necessary protection to both the buyer and the seller. The price of the futures contract can change prior to delivery. Hence, both participants must settle daily price changes as per the contract values.

An Example of a futures contract would be an agreement to 100 tonnes of Steel at Rs. 10000/- per tonne at some date say in December 2008. If no interim payments are made and if the price of Steel moves violently, a considerable credit risk could build up. To avoid this a margin system is used by the exchanges. As per the margin system, both parties must deposit a small sum with the exchange. This amount will be a small percentage of the total contract. This amount is called the initial margin. As the steel value changes, the contract value also changes. If the contract value changes, the margin must be topped up by an amount corresponding to the change in price of steel. The margin money is the property of the person who deposits it and would be returned to them if the contract gets cancelled/completed.

Characteristics of Futures contract:

1. They are traded in organized exchanges

2. Credit risk is eliminated with the margin system. Both parties deposit a portion of the contract with the clearing house.

3. Both the buyer and seller are bound by the contract terms and are expected to honour their end of the contract.