Putting it in simple legal terms, when two or more competent parties voluntarily and legally sign an agreement, which binds them together, it is 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 contract and forward contract (Ratnashri, 2010).
Forward contract 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 forward 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.
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.
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 versus 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. Future contracts trade on the floor of future exchange, and thus their transactions are managed by a broker, who is a member of that exchange. The party who has made the future contract remains anonymous.
Forward Contract versus Future Contract
Categories | Forward Contract | Future Contract |
Structure | Usually no initial payment is required. This contract is customised 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. | Standardised 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. |
The major disadvantage of future contract is that it increases the chances of risk. But still, despite the risk involved in dealing with an anonymous party, people are still going in for a future 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 future 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 are called ‘marked to the market’.
Dutta, R. (2010). Forward-contract-vs-future-contract. http://www.buzzle.com/articles/ forward-contract-vs-future-contract.html
