How Forward Contracts Differ from Exchange-Traded Expiry Futures
Summary
The document compares two ways to agree on a future asset trade. A forward is a private, customizable over-the-counter agreement: the parties choose the asset, price, size, and settlement date. The example of an airline arranging a future jet-fuel purchase illustrates how a forward can hedge against a rise in the spot price, while leaving both parties exposed to the risk that the other may not perform. Forwards typically do not require an upfront margin payment, but their limited liquidity can make it hard to exit early.
Expiry futures are standardized contracts traded on exchanges and supported by a clearinghouse. Daily mark-to-market settlement and initial and maintenance margin requirements help manage performance risk; falling below the required balance can lead to a margin call and closure. Exchange trading can provide transparency and liquidity, but contract terms are less flexible and fees may apply. The comparison is a general overview rather than a quantitative analysis, and its statements about regulation, risk elimination, costs, and delivery should not be treated as universal across markets or contracts.
Key ideas
- A forward lets two parties customize the asset, price, size, and settlement date of a future trade.
- Forwards can support hedging but expose each party to counterparty default and may be difficult to exit.
- Expiry futures use standardized terms and trade on exchanges through a clearinghouse.
- Margin and daily settlement help manage futures performance risk, while insufficient margin may result in position closure.
- Futures generally offer more transparency and liquidity than forwards, at the cost of flexibility and potentially added fees.
Tags
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.