What are the differences between a forward contract and a futures contract?
The logic of using a futures contract is very similar to using a forward contract. Both concern transactions of an underlying asset (either commodities or financial securities) that are going to take place sometime in the future. But there are some important differences between them.
A forward contract is signed between party A and party B face to face (or ‘over the counter’), whereas in a futures contract there is an intermediary between the two parties. This intermediary is often called a clearance house, which is a part of a stock exchange. The two parties do not work directly with their counterpart; rather, each party works with the clearance house that is monitoring the transaction. This implies that the default risk that may appear problematic in a forward contract is significantly reduced in a futures contract.
A forward contract is signed based on the agreement between the two parties regarding the price, the quality and the quantity, as well as the delivery date of the underlying asset. They are not standardised. However, in a futures contract the transaction is standardised in terms of the quantity, the quality, and the delivery date.
A forward contract usually only has one specified delivery date, whereas there is a range of delivery dates in a futures contract.
A forward contract can normally be settled on the delivery date, either by delivering the underlying asset or by making a financial settlement. However, in the futures market the transaction is settled on a daily basis, which is called mark-to-market. In addition, there is no deposit requirement for signing a forwards contract. But in the futures market the investor has to put some initial deposit into her trading account, which is known as the initial margin requirement. If this deposit reaches the minimum level (known as the maintenance margin), the clearance house will ask the investor to add further deposits to sustain her trading. The margin requirement in the futures market implies that trading in the futures market is highly leveraged.
A forward contract is not formally regulated, whereas a futures contract is regulated by the stock exchange where the clearance house is situated.
Although futures would appear to have many advantages over forwards, and futures market are regulated and standardised, forward contracts are still necessary, particularly for suppliers and manufacturers in the real (non-financial) sector. Because of high uncertainty surrounding their operations, they need to manage their risk in a particular way.
We stated that futures trading is highly leveraged because the clearance house requires traders to deposit only a margin.
Why do you think the margin requirement creates leverage, and what are the implications of this?
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