A forward contract is a private agreement between two parties to buy or sell an asset at a future date and at a specified price. The terms of the forward contract are determined by the parties involved in the contract, and they are not standardized. The lack of standardization of forward contracts means that they are not traded on exchanges and are not fungible.
On the other hand, a futures contract is a standardized contract that is traded on an exchange, and it obligates the buyer or seller to buy or sell an underlying asset at a future date and at a specified price. The terms of futures contracts are determined by the exchange where they are traded, and they are subject to daily margin requirements.
The main differences between forward and futures contracts are as follows:
1. Standardization: Futures contracts are standardized, which makes them fungible and tradable on exchanges. Forward contracts are not standardized, which makes them less liquid.
2. Counterparty risk: In a forward contract, there is a risk that one of the parties may default on their obligations. In a futures contract, the exchange acts as a counterparty to both parties, which eliminates this risk.
3. Margin requirements: Futures contracts require daily margin payments to be made by both parties to ensure that they fulfill their obligations. Forward contracts do not have margin requirements.
4. Settlement: Futures contracts are settled daily through a clearinghouse, which ensures that both parties fulfill their obligations. Forward contracts are settled on the maturity date.
5. Cost: Futures contracts generally have a lower cost than forward contracts because of the competition among market participants on the exchange.
In summary, while both forward and futures contracts are agreements to buy or sell an asset at a future date and at a specified price, the main differences include standardization, counterparty risk, margin requirements, settlement and cost.