People who have just started off a new business or are planning to start one, need to know the difference between forward and future contracts. Just read ahead to know what they mean and how they differ from each other.
Putting it in simple legal terms, when two or more competent parties voluntarily and legally sign an undertaking, which binds them together, it’s called a contract. Sometimes, you as a seller or buyer, may have to get into an arrangement with the other party. These agreements are broadly categorized into future and forward contracts. But several people who are new to business, have no idea as to how these two are different from each other. For these people, given below are some pointers in order to understand the usage and significance of both.
What is a Forward Contract?
This type of contract is actually a private pact between the buyer and the seller. Here, both the parties agree to buy and sell a predetermined quantity of products or services, at a price which is mutually decided. These products or services are also known as underlying instruments. This contract differs from others in a way that the delivery and payment of the agreed product or the underlying instrument does not take place immediately, but on the specified future date, which is mentioned in the agreement.
Let me explain this to you with the help of an example. The year is 2014. You own a shoe company called ABC Ltd. Mike, a shoemaker, agrees to sell you 1000 pairs of shoes, with each pair costing USD 25, in the year 2015. He does this even before he starts making the shoes. The actual exchange of the shoes and money will only take place after Mike has made them. By getting into an agreement, you have protected yourself against the risks that might have affected you.
Mike has protected himself against a decrease in price, than the agreed price, while on the other hand, you have protected yourself against the increase in price. Both of you have eliminated the risk of getting a bad price for your shoes.
Now, the shoes are ready to be sold. It might be that due to normal circumstances which affect the demand and supply, the price of the shoes might increase to say USD 30 a pair. This is when Mike wishes that he had not entered into the agreement of selling it for USD 25 a pair. On the other hand, your company will be earning profits and you will get the USD 30 shoes for USD 25.
But if the price falls to USD 20 a pair, then you will incur losses, as you have to buy shoes for USD 25 instead of USD 20. Therefore, if the agreed price is higher than the current price, then Mike is happy. But you as a buyer will benefit, if the contracted rates are lower than the market price.
To avoid any kind of complications in the future, before signing an undertaking, as a seller or even as a buyer, make sure that all terms and conditions are clear to you. There must be no confusion regarding delivery terms, locations, quality of the agreed products, credit terms, payment terms, etc. Sign the deal only if you are willing to abide by all the clauses mentioned in the contract.
What is a Future Contract?
Another type of undertaking that can be signed between a seller and a buyer is known as a future contract. This agreement is also made for the sale or purchase of a product or service at some time in the future. However, when it comes to comparison between forward and future contracts, the latter is publicly traded, while the former is privately traded between people who know each other. These deals trade on the basis of future exchange and their transactions are managed by a broker, who is a member of that exchange. The party who has made the deal remains anonymous.
For instance, your company ABC Ltd., gets into an arrangement to purchase 20,000 shoes. You have no idea who is the actual seller, as the entire transaction is being managed by a middleman, or a broker. The major disadvantage of this form of undertaking is that it increases the chances of risk.
But, despite the risk involved in dealing with an anonymous party, people are still going in for this agreement, because of the exchange that facilitates the transaction and guarantees all trades. The exchanges are also backed by insurance policies, lines of credit, and verification of the financial background of the members who are involved in the transaction.
Risk is also reduced as the members formulate strict rules regarding the arrangement and the counter parties. Customers who are getting into these deals, need to pledge some security deposit, which is called a margin. They have to pledge this against their market positions. They also have to cover their losses regularly, which according to them is called ‘marked to the market’.
Future Contract vs Forward Contract
| Categories | Forward Contract | Future Contract |
| Structure | Usually, no initial payment is required. This contract is customized as per the needs of the customers. | Initial margin payment is needed. This contract is customized 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 a different counter party remains. | There is an opposite contract on the exchange. |
| Size | 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 government regulated. |
| Definition | Agreement between two or more parties to buy or sell a product, on a pre-agreed date in the future. | Standardized 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. |
| Date of expiry | Depends on the contract. | Expiry date is standardized. |
| Method of transaction | Direct negotiations between the buyer and the seller. | Transaction takes place at the exchange. |
| Institutional guarantee | Contracting parties | Clearing house |
| Guarantees involved | No guarantees involved. Once the agreement has been made, it is very difficult to undo it till the expiry date is over. | Both the buyer and 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. |
Now that you know the difference, it will be easier for you strike a deal next time, when you are purchasing any product or ‘underlying instrument’.