Futures and forward contracts are similar since they are both agreements to buy or sell an asset at a certain time in the future for a certain price. There are some significant differences.

Forward contracts are negotiated privately by banks between two parties. Because forward contracts are negotiated, the details of the contract can be as unique as the needs of either party, including such things as how much or what is being exchanged, how it is delivered, for what type of price or payment schedule. Futures contracts are standardized as to quantity and quality of the exchanged product, as well as specific expiration dates. All that is variable is the price of the contract.

Because forward contracts are negotiated between two parties, the credit- worthiness of both parties comes into play. Specifically, both parties are solely responsible for delivering the product and providing the funds in the exchange as the “counterparty” to the trade. While slight, there is still a potential for counterparty failure to pay or deliver; witness for example how this risk led to the collapse of the sub-prime market. Conversely, futures are exchange traded, with the exchange acting as the counterparty to every trade. This greatly reduces the counterparty risk, as the entire financial strength of the exchange is available; witness not a single counterparty failure in over 100 years of exchange traded futures.

Forward contracts typically are held to maturity, with the contract settled on a specific date by exchange of either the product or funds. Future contracts, on the other hand, are “marked-tomarket” every day, resulting in funds being credited or charged to each trading account based on the market closing price. Only three percent of all futures contracts are held to contract expiration.