In the world of investing, there are many more options available than the traditional stocks, bonds, mutual funds and ETFs you may be familiar with. But because diversifying your investments is one of the most common investing tips, understanding what other assets and strategies are available is wise. Doing so gives you the ability to customize your approach to investing and build a strong portfolio.
As you’re exploring the various investment methods you have access to, you might come across forward and future contracts. While the two sound a lot alike based on their names, there are some key differences you’ll want to consider. This ensures you can pursue the option that’ll be most beneficial to your portfolio when you’re choosing investments. If you’re wondering what the difference is between forward and future contracts, here’s what you need to know.
A forward contract — also referred to simply as a “forward” — is an agreement between two private parties outlining the sale of a specific asset on a defined date for an agreed-upon purchase price. Essentially, it’s a direct arrangement between an individual buyer and seller.
Additionally, a forward contract is traded privately, using a process that’s commonly called an over-the-counter trade. There isn’t a formal exchange involved in the creation or execution of the contract.
In most cases, forwards are used for hedging. They’re inherently speculative in nature. However, investors sometimes find other uses for them.
Pros and Cons of Forwards
When it comes to the benefits of forwards, the biggest is the ability to fully customize the contract terms. Additionally, most don’t require an initial payment. The underlying asset involved can be of any type, not just stocks, bonds, ETFs or similar investment vehicles. Any negotiating also takes place directly between the buyer and seller, which gives both parties more influence over the agreement.
As for drawbacks, the lack of regulation can be problematic. In addition, the lack of any required deposit limits any potential guarantees, and there’s a high counterparty risk — meaning that it’s easier for either party in the contract to default or avoid fulfilling their end of the bargain.
What Is a Future Contract?
A future contract — also called a “future” — is an agreement to purchase a specific asset at a particular time for a set amount of money. In that regard, it isn’t unlike a forward contract. The arrangements themselves include the same types of details.
However, futures are standardized and publicly traded on futures exchanges, such as the Chicago Mercantile Exchange. This adds a level of formality that isn’t present with forwards.
When it comes to uses, futures are speculative in nature. So, investors typically turn to them when they feel strongly about the potential of a particular asset to gain or lose value.
Pros and Cons of Futures
With futures, one of the major benefits is standardization, both when it comes to the contracts themselves and how they’re traded. Futures contracts are also regulated, which can provide more peace of mind. There’s also low counterparty risk.
As for drawbacks, an initial margin payment is required. Additionally, futures are limited to more traditional investment vehicles.
It’s also important to note that pricing largely depends on the futures market, not individual preferences. As a result, there’s increased standardization, which can be beneficial. However, that’s coupled with less customization, which may be a downside for some investors.
What Is the Difference Between Forward and Future Contracts?
Futures and forwards have a significant amount in common. Both involve a commitment between two parties — a buyer and a seller — in regard to a particular asset. The contract will specify a price for the asset and a contract maturity or expiration date, essentially outlining what will be purchased when, along with how much that sale is worth.
Usually, the most significant difference between forwards and futures is whether a formal exchange is involved. For forwards, the buyer and seller interact directly and handle the transaction privately. With futures, there’s an exchange, like the Chicago Mercantile Exchange, involved. As a result, futures are more standardized, while forwards are more customizable.
With forwards, it’s also possible to create contracts for any type of asset, including those that aren’t traded on typical markets. With futures, the contracts are limited based on the nature of the exchange, with some focusing on stocks, bonds, currencies, commodities or other products. While the futures market does include a significant amount of variety, it isn’t as broad as what you can do with a forward contract.
It’s also important to note that futures are settled daily. That allows involved parties to buy or sell them at any time, even if the maturity date is significantly down the line. As a result, the contracts themselves are more tradable.
Examples of Forwards and Futures
Forward Contract Example
Erik runs a bike repair shop, and he uses Tires R Us to get tires for the bicycles he services. Erik pays Tires R Us $10 per tire, which leaves him enough room for a healthy profit on the tires he sells to customers. However, Erik heard that there will be a rubber shortage this year due to a short-term supply chain issue. He’s worried that Tires R Us will soon face inventory struggles that lead to higher prices.
Tires R Us doesn’t think the rubber shortage will be a problem because it’s recently partnered with an extra supplier. In fact, Tires R Us believes it may have excess inventory compared to the previous year.
However, Erik knows a price increase would hurt his profitability regardless. So, he negotiates a forward contract with Tires R Us, agreeing to purchase 500 tires for $10 each ($5,000 in total) in six months. If the rubber shortage happens, Erik comes out ahead. However, if Tires R Us ends up with excess inventory, it might lower its tire prices, causing Tires R Us to secure a financial gain when the contract matures instead.
Future Contract Example
Erik’s bike shop purchases tires for $10 apiece currently. But, as mentioned, a potential rubber shortage could cause prices to rise and subsequently hurt his profitability. As a means of maintaining healthy margins, Erik looks at bicycle tire futures contracts that mature in six months. He can purchase contracts on an exchange for $1,000 each, with one contract equaling 100 tires. Erik buys five contracts, setting himself up to get 500 tires for $5,000.
If the rubber shortage occurs, Erik can sell his five contracts for more than he paid. This allows him to secure a large enough gain to offset the change in price. If the rubber shortage doesn’t happen, then he may break even. However, if rubber is more accessible than expected, the price of tires could fall, causing Erik to have to sell for a loss.