Futures contracts and forward contracts are similar in concept but are used for different purposes.
With a futures contract or a forward contract, you agree to buy or sell a currency at a specific time in the future. However, these instruments aren’t the same. In fact, you’ll see significant differences between them when you consider what they’re used for.
What’s the difference?
Futures contracts and forward contracts diverge in a few key areas.
Futures contracts are more rigid; forward contracts more flexible
A futures contract is standardized, meaning that they’re held to specific underlying terms that mean the same thing to everyone in the market. You can’t change many of these terms.
On the other hand, a forward contract is more flexible — since it’s an agreement with another party, you have more leeway to change its terms.
Risk of default
A futures contract is backed by a clearing house — or a financial intermediary — so it’ll almost never be defaulted on. On the other hand, a forward contract is a private agreement, so it could be defaulted on.
What does it mean to “default” on a contract?
When a contract is at risk of default, it means that there is a possibility that one of the parties may not be able to fulfill its obligation specified in the contract. If your contract involves a financial intermediary, like a clearing house, the intermediary typically protects you against default.
The window for fulfillment is different
A futures contract is marked to market every day, meaning its value is appraised daily. This means you can close out your position in the agreement before the contract’s maturity. Meanwhile, you can only close out a forward contract at its maturity date.
Investors use futures contracts and forward contracts for different goals
Most investors who hold futures contracts are speculators — they trade riskier currencies hoping to make large returns. Most investors who hold forward contracts are people who want to insulate themselves from fluctuations in a currency’s exchange rate.
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When should you use a futures contract vs. a forward contract?
The mechanics of futures contracts and forward contracts are similar. But as we’ve discussed, these two contracts are used for very different reasons.
One of the biggest differences is risk. With a futures contract, you’re quite tolerant of risk. With a forward contract, you’re a hedger trying to avoid volatility.