Forward contracts are another type of contractual agreement where a buyer and seller agree on a specific price and date to exchange an asset. Whereas futures are traded on an exchange, forward contracts are regarded as over-the-counter (OTC) products and therefore, they can often be customised at a certain point throughout the contract. Futures contracts are standardised, which means that their terms and conditions are non-negotiable once set at the beginning.
Furthermore, the daily settlement in futures contracts differs from that of forwards trading. As implied, futures prices are settled on a daily basis until the expiration date of the contract, whereas forward cash settlement only occurs at the very end of the contract. However, it is possible with both methods to close the position early.
The value of futures contracts is also reflected in the fact that futures trading involves a clearinghouse. This guarantees that the performance of each transaction will go ahead and this is not an option in forwards trading, meaning that defaults are more likely and there is a higher credit risk.
There are advantages and disadvantages for each type of contract. On the one hand, hedgers usually prefer to trade forwards in order to avoid asset volatility, as speculating on the price of a commodity in the future, for example, can be a difficult task. Financial markets are constantly fluctuating and whereas forwards prices are set more firmly at the beginning of an agreement, futures prices are more flexible.
On the other hand, experienced traders may welcome the opportunity to trade on volatility, as this can increase the income profits if successful. However, one wrong move in a volatile market can wipe out your entire capital, as trading futures with leverage comes with many risks. Futures contracts often come with a higher leverage ratio, meaning that even a small drop in price action could lead to magnified losses.