Distinction between Futures and Forward

There are several key differences between futures and forward contracts:

Standardization: Futures contracts are standardized, while forward contracts are customized. Futures contracts specify standardized terms and conditions, including the underlying asset, contract size, delivery date, and price, which are the same for all contracts traded on the exchange. Forward contracts, on the other hand, are privately negotiated between the buyer and seller, and can be customized to meet the specific needs of the parties involved.

Trading location: Futures contracts are traded on organized exchanges, while forward contracts are traded over-the-counter. Futures exchanges provide a centralized marketplace for trading and provide a transparent pricing mechanism for all market participants. In contrast, forward contracts are privately negotiated between the buyer and seller, and are not traded on organized exchanges.

Counterparty risk: Futures contracts are subject to daily marking-to-market and margin requirements, which help to minimize counterparty risk. In contrast, forward contracts are subject to counterparty risk, which is the risk that one party may default on the contract.

Liquidity: Futures contracts are highly liquid, with a large number of buyers and sellers in the market. This makes it easy for market participants to enter and exit positions at any time. In contrast, forward contracts are less liquid, with a smaller number of buyers and sellers in the market.

Price discovery: Futures exchanges provide a transparent pricing mechanism that reflects the supply and demand for the underlying asset. This helps to ensure that the price of futures contracts accurately reflects the current market price of the underlying asset. In contrast, the price of forward contracts is negotiated between the buyer and seller, which can make it more difficult to determine the fair value of the contract.

Overall, while both futures and forward contracts provide a mechanism for hedging against price fluctuations, futures contracts offer several advantages over forward contracts, including standardization, trading location, counterparty risk management, liquidity, and price discovery.