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What’s the difference between futures and forward contracts?
Though similar, these agreements are designed for different purposes.
Futures and forward contracts allow you to buy or sell a currency at a specified time in the future. But these two agreements differ significantly when you consider their use, structure and more.
How do futures and forward contracts differ?
Key differences between futures and forward contracts lie in their specificity, risk, transaction windows and goals.
Flexibility on terms and conditions
A futures contract is a standardized agreement to buy or sell assets and commodities like currency at a set price or value on a specific date. Unlike with forward contracts, contracted futures are traded on a regulated exchange. That structure leaves little room to change the underlying terms or conditions of the agreement. Instead, the buyer is obligated to take ownership of the asset the seller is providing on the contract’s settlement date — the date at which the contract expires.
A forward contract is a private agreement between a buyer and a seller to sell an asset at a set price in the future, not necessarily on a set date. Because they are privately negotiated agreements, you often have more flexibility to customize the terms and conditions of your agreement.
Possibility of default
A futures contract is traded on an exchange and backed by a clearing house. The support of that financial intermediary drops the risk of default significantly.
A forward contract is a private agreement between two parties. The contract depends on each party to fulfill their end of the agreement, leaving room for default if either the buyer or seller isn’t able to.
What does it mean to default on a contract?
Default occurs when a party is no longer able to fulfill their obligations under the contract’s terms and conditions. It could mean that a buyer no longer has the money to purchase the asset they agreed to buy under the contract or a seller no longer has that asset to sell.
When a contract involves a clearinghouse, that financial intermediary typically protects you by taking on the risk of default. In the simplest terms, they agree to satisfy the requirements of either the buyer or the seller in the event that one party cannot.
Window for fulfillment
A futures contract is marked to market every day, meaning the value of the asset is appraised daily. You can close out your position in the agreement before the contract’s maturity.
With a forward contract, you can close out the asset at its maturity or settlement date only.
Goals and returns
Most investors who hold futures contracts are speculators looking to trade riskier currencies with the hope of large returns. Whereas many people who hold forward contracts want to insulate themselves from fluctuations in a currency’s exchange rate.
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A futures contract is best for advanced investors who can tolerate risk in the value of the asset they’re looking to buy or sell within the rigidity of a regulated, standardized agreement. For those looking merely to hedge or avoid volatility, look into a private, more flexible forward contract.
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