Forwards and futures are both contracts in which the seller of the derivative promises to sell an asset at a specific point in the future for a predetermined price (the ‘strike price’).
Forwards and futures are however traded in different ways.
Forwards
Contracts in which the parties involved agree to buy or sell assets at a specific point in the future for a predetermined price. Forwards are instruments that can be privately traded between two different parties over the counter (OTC), meaning that there is no need for a listing on a public exchange. The parties can personally negotiate terms that are tailored to suit their specific requirements and help fulfil their particular objectives, such as the date of delivery and the price to be paid in the future. Forwards give rise to some degree of counterparty risk, as if one party defaults (either on the promise to pay, or the promise to supply goods in the future) and becomes insolvent, the other party may lose out, subject to any remedy to which they may be entitled under insolvency law.
Futures
Contracts in which the parties involved agree to buy or sell assets at a specific point in the future for a predetermined price. In contrast to forwards however, futures are instruments traded on public exchanges. Futures contracts usually incorporate predetermined terms and conditions and thus, unlike forwards, are not individually negotiated and tailored to suit the specific needs of the parties involved. It is worthy to note that trading futures can involve lower counterparty risk than trading forwards, as futures are traded through a centralised clearing house that requires members to maintain sufficient funds to (at least partially) cover their debts.
It is important to note that anyone entering a forwards or futures agreement has a legal obligation to deliver whatever is promised by the predetermined date. For example, if the contract states that 100 barrels of oil must be delivered on the 20th September for $100 per barrel and on the 20th September the price is $90, the owner of the forward or future cannot renege on their agreement to buy purely because the price fluctuations in the market have resulted in the deal becoming less beneficial. In this sense, they are taking the risk when entering into the derivative contract that they will not end up worse off financially.
The use of forwards and futures is widespread. Organisations primarily utilise forwards and futures in order to ensure that they will receive sufficient quantities of required assets in the future and to lock in future prices in order to help manage and stabilise cash flows (through enabling more accurate future cost-predictions). For instance, airlines may purchase forwards to lock in the price of oil, thus enabling them to set future prices safe in the knowledge that their projected profit margins will be protected. Failure to utilise derivative contracts could ultimately expose them to significant cost increases (which may end up destroying profit margins) if, for instance, an unforeseen macroeconomic shock occurs (such as a crisis that affects the supply, and thus the price of oil).
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By Jake Schogger - City Career Series