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Forward Contract vs Futures Contract

A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time at a pre-agreed price. A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. So while the date and price are decided in advance in forward contract, a futures contract is more unpredictable. They also differ in the forms that a futures contract is standardized while a forward contract is made to the customer's need. Standardization and exchange based trading of futures is the underlying reason for most of the differences between a forward and future transaction. Even though it may be intuitive that future trades are more constrained than forward trades and should hamper efficient markets, the standardization of the contracts stimulates futures market and enhances liquidity. In contrast to forward contracts in which a bank or a brokerage is usually the counterparty to the contract, there is a buyer and seller on each side of a futures trade. The futures exchange selects the contract it will trade. Comparison chart Improve this chart Forward Contract Futures Contract

Guarantees:

No guranantee of settlement until the date of maturity only the forward price, based on the spot price of the underlying asset is paid

Both parties must deposit an initial guarantee (margin). The value of the operation is marked to market rates with daily settlement of profits and losses. Standardized Quoted and traded on the Exchange Standardized

Expiry date: Transaction method: Contract size:

Depending on the transaction Negotiated directly by the buyer and seller Depending on the transaction and the requirements of the contracting parties. The contracting parties

Institutional guarantee: Market regulation:

Clearing House

Not regulated

Government regulated market

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Forward Contract

Futures Contract

Meaning:

A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a preagreed future point in time.

A futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price.

Risk:

High counterparty risk

Low counterparty risk

Structure:

Customized to customers need. Usually no initial payment required.

Standardized. Initial margin payment required.

Method of pretermination:

Opposite contract with same or different counterparty. Counterparty risk remains while terminating with different counterparty.

Opposite contract on the exchange.

Contract Maturity:

Forward contract mostly mature by delivering the commodity

Future contracts may not necessarily mature by delivery of commodity

DERAVATIVE
A derivative is a financial agreement that has its value determined from the price of a certain asset, commodity, rate, index or the happening or significance of an event. The meaning of the word derivative itself comes from the way in which the value of these agreements are derived from the price of the item of significance. There are many known examples of derivatives such as futures, swaps, forwards, and options, all of which can be joined with traditional securities and loans thus creating structured securities, also commonly referred to as hybrid instruments.

FORWORD CURRENCY
A Forward (Cash) Contract is an accord whereupon a seller consents to pay a specific commodity in cash to a buyer at some point in the future. Forward contracts are different from futures contracts in that they are not standardized and are negotiated privately. People in the market often wish to exchange currencies at an unspecified time in the future, however it is beneficial to know the current rate of exchange. Forward foreign exchange contracts are commonly used by importers, exporters as well as investors who attempt to lock in exchange rates in advance so that they can be used at a future time thus hedging their foreign currency cash flows.

Definition of 'Currency Swap'


A swap that involves the exchange of principal and interest in one currency for the same in another currency. It is considered to be a foreign exchange transaction and is not required by law to be shown on a company's balance sheet.

Investopedia explains 'Currency Swap'


For example, suppose a U.S.-based company needs to acquire Swiss francs and a Swissbased company needs to acquire U.S. dollars. These two companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount and a common maturity date for the exchange. Currency swap maturities are negotiable for at least 10 years, making them a very flexible method of foreign exchange.

Structure
Currency swaps are over-the-counter derivatives, and are closely related to interest rate swaps. However, [1] unlike interest rate swaps, currency swaps can involve the exchange of the principal. There are three different ways in which currency swaps can exchange loans: 1. The simplest currency swap structure is to exchange only the principal with the counterparty at a specified point in the future at a rate agreed now. Such an agreement performs a function equivalent to a forward contract or futures. The cost of finding a counterparty (either directly or through an intermediary), and drawing up an agreement with them, makes swaps more expensive than alternative derivatives (and thus rarely used) as a method to fix shorter term forward exchange rates. However for the longer term future, commonly up to 10 years, where spreads are wider for alternative derivatives, principal-only currency swaps are often used as a cost-effective way to fix forward rates. This type of currency swap is also known as an FX[2] swap. 2. Another currency swap structure is to combine the exchange of loan principal, as above, with an interest rate swap. In such a swap, interest cash flows are not netted before they are paid to the counterparty (as they would be in a vanilla interest rate swap) because they are denominated in different currencies. As each party effectively borrows on the other's behalf, this type of swap is [2] also known as a back-to-back loan. 3. Last here, but certainly not least important, is to swap only interest payment cash flows on loans of the same size and term. Again, as this is a currency swap, the exchanged cash flows are in different denominations and so are not netted. An example of such a swap is the exchange of fixed-rate US dollar interest payments for floating-rate interest payments in Euro. This type of [3] swap is also known as a cross-currency interest rate swap, or cross currency swap.

Uses
Currency swaps have two main uses: To secure cheaper debt (by borrowing at the best available rate regardless of currency and then [2] swapping for debt in desired currency using a back-to-back-loan). [2] To hedge against (reduce exposure to) exchange rate fluctuations.

Hedging example
For instance, a US-based company needing to borrow Swiss francs, and a Swiss-based company needing to borrow a similar present value in US dollars, could both reduce their exposure to exchange rate fluctuations by arranging any one of the following: If the companies have already borrowed in the currencies each needs the principal in, then exposure is reduced by swapping cash flows only, so that each company's finance cost is in that company's domestic currency. Alternatively, the companies could borrow in their own domestic currencies (and may well each have comparative advantage when doing so), and then get the principal in the currency they desire with a principal-only swap.

HISTORY
Currency swaps were originally conceived in the 1970s to circumvent foreign exchange controls in the United Kingdom. At that time, UK companies had to pay a premium to borrow in US Dollars. To avoid this, UK companies set up back-to-back loan agreements with US companies wishing to [6] borrow Sterling. While such restrictions on currency exchange have since become rare, savings are still available from back-to-back loans due to comparative advantage. Cross-currency interest rate swaps were introduced by the World Bank in 1981 to obtain Swiss francs and German marks by exchanging cash flows with IBM. This deal was brokered by Salomon Brothers with [7] a notional amount of $210 million dollars and a term of over ten years.