What is the difference between forward contracts and futures contracts in AFM?
GradeHunt_TeamGradeHunt Team · · CA Final
In CA Final AFM derivatives and forex, I need to write a theory answer on forwards vs futures. Which key points should I cover?
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Both lock in a price today for a transaction on a future date. They differ in how they are traded and settled.
Forward contract:
- Private agreement between two parties, traded over the counter.
- Terms (quantity, date, price) are customised.
- Settled on maturity, usually by delivery.
- Counterparty risk exists, since there is no clearing house.
- No margin or daily settlement; no cash flows until maturity.
- Less liquid; it cannot simply be sold to someone else, so cancellation, early delivery or extension has to be arranged with the same counterparty (usually the bank). The bank settles the rate difference with the customer, which can be a gain or a loss, and may add charges.
Futures contract:
- Standardised contract traded on an exchange.
- Fixed lot sizes and expiry dates.
- The clearing corporation guarantees performance, so counterparty risk is minimal.
- Initial margin is required, and gains or losses are settled daily (marking to market).
- More liquid; a position can be closed out before expiry by taking an opposite position on the exchange.
- Most positions are closed out before expiry. Positions held to expiry are settled as per exchange rules: in India, index and currency futures are cash-settled, while stock futures are settled by physical delivery.
When each is used:
- Forwards suit exact hedges, for example an importer paying a fixed USD amount on a fixed date.
- Futures suit flexible hedging and trading, but standard lot sizes and fixed expiry dates may leave part of the exposure unhedged or create a date mismatch (basis risk).
Exam tip: present this as a comparison with three columns (basis, forward, futures) and at least six points. In practical questions on futures, show the daily mark-to-market working and the margin account, including any margin call, as a separate step.
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