Forward contracts vs expiry futures: what are the differences?

Expiry futures are actively used within the crypto space and have become a tool in many trader's arsenal. Expiry futures are derivatives, meaning their value is derived from the price of the underlying assets. So, if you buy a Bitcoin futures contract, you're not taking possession of it but speculating on its price fluctuation.

The concept of expiry futures comes from forward contracts. Forward contracts are one of the oldest financial instruments around today. They date back centuries when farmers and merchants wanted to hedge against price fluctuations. Today, forward contracts are still used by businesses for hedging purposes. This article will explain futures vs forward contracts and discuss their advantages and disadvantages.

What is a forward contract?

A forward contract is an agreement between two parties to purchase an asset in the future at a price agreed upon today. For example, the jet fuel price today is $10 per gallon. An airline company and a jet fuel company can enter into a forward contract to purchase a certain amount of fuel at $11 per gallon 6 months from now.

In the above scenario, $10 per gallon is the spot price, and $11 per gallon is the ¨forwards price¨. The price of jet fuel could go up or down in the next six months. If the price increases to $12 in six months, the airline company can purchase it at $11 per gallon, getting a discounted rate. If the price drops to $9 per gallon, the airline must pay $10 to honor its forward contract terms. Now, let's discuss how this type of transaction comes about.

How the forward market works

The forward market is customizable. Any two parties can enter into a forward contract. They can agree on the underlying asset they want to exchange. They can set their pricing and determine their settlement date or the contract's maturity.

The forward market occurs over-the-counter (OTC). That means they occur privately between two parties, not on an exchange platform. For this reason, they aren't regulated by a third party. The two parties are bound by the contract, which is legally enforceable.

Forward contract advantages

Forward contracts have many advantages for people looking to hedge against the price fluctuation of assets in the future.

• The first advantage is that the two parties don't have to send a down payment to enter into a contract.

• The second advantage is that it is customizable, meaning participants can determine the underlying asset they wish to trade and the contract's settlement price.

• The third advantage is that the contract takes place over the counter. That gives forward contracts a level of privacy.

Forward contract disadvantages

• The first disadvantage is that forward contracts carry a lot of counterparty risks. This means that there is a chance that either party can default on carrying out their contractual obligations.

• The second disadvantage is that forward contracts are highly illiquid. Very few buyers and sellers are willing to buy the contracts. This may make it difficult for both parties to get out of a forward contract.

What is expiry futures?

Expiry futures is a standardized contract traded on an exchange and marked to market daily. Traders can use expiry futures to open long(buy) or short (sell) positions against an underlying asset. Let's unpack what this means by discussing how the futures market functions.

How the futures market works

Expiry futures are standardized. This means the underlying asset, the size of the contract, the price, and the settlement date are predetermined.

Expiry futures are traded on public exchange platforms. That gives them a lot of liquidity. However, buyers and sellers on exchange platforms don't deal with expiry futures directly with one another. Instead, a clearinghouse is an intermediary between the sellers and the buyers.

When a trade occurs, the buyer and the seller submit their trades to the clearinghouse. The clearinghouse verifies the details of both parties and facilitates the settlements. This guarantees the performance of the contract and eliminates counterparty risk.

The clearinghouse enforces margin requirements with every trade position. Margin refers to the initial and maintenance amount traders must deposit to offset expiry futures losses. In a futures contract, parties need to maintain a minimum balance determined by the price and size of their position. If the balance decreases below this amount, they'll receive a margin call to top up their funds to maintain the position. Should they fail to heed the margin call, their trading position is automatically closed, and the contract is terminated.

Expiry futures advantages

Expiry futures have many advantages for people looking to hedge or speculate on the price of assets in the future.

• The first advantage is that the contracts are standardized. This means underlying asset costs and settlement periods are readily available for public viewing, making them more transparent and creating a fairer trading environment.

• The second advantage is that clearinghouses facilitate expiry futures. This reduces counterparty risks and makes sure that trades are performed according to the term stipulated by the contract.

• The third advantage of expiry futures is that they are highly liquid. Participants can quickly exit their positions should things go in a different direction.

Expiry futures disadvantages

• The first disadvantage of expiry futures is the cost and fees involved. Expiry futures are considered expensive because the daily settlements of differences between accounts can incur additional transaction fees.

• The second disadvantage is that they aren't customizable. Traders are limited to the selection of underlying assets set by the exchange. They also don't have a say in determining the contract's size, price, and fees.

Which type of contract is better?

In summary, here are the two key differences between expiry futures vs forwards contracts:

Expiry futures take place on a trading exchange. The exchange platform determines the price, size, and underlying asset. Forward contracts, on the other hand, occur over the counter. Meaning they're private agreements between two parties. The two parties agree on the price, the size, and the underlying asset.

Expiry futures require initial and maintenance margins to open a position. The clearinghouse facilitates daily account settlements between the buyers and sellers, illuminating counterparty risk. Forward contracts, on the other hand, don't require money upfront. The two parties only exchange money at the end of the contract or settlement date, which is why they carry massive counterparty risk.

FAQs

What's the difference between the forward market and the futures market?

A forward market occurs over-the-counter (OTC). It's private and unregulated. A futures market occurs on an exchange platform, facilitating trades through a clearinghouse. In the US, exchanges are regulated by the CFTC or SEC.

Why choose forward over expiry futures?

Traders may prefer a forward contract over expiry futures because it's a cheaper derivative to maintain. They are a better financial instrument when a trader wants delivery of a commodity.

What's the difference between forward contracts and options?

Forwards and options are both derivatives for hedging or speculating. A forward contract obligates the trader to fulfill the terms of the agreement. An options contract gives the trader an option to fulfill the contract terms.