The instrument that drives its value from the price of another asset (Underlying asset). And the underlying asset could be equity, index, forex, commodity or any other asset.
Futures & Forwards
It is a contract between two entities, where settlement takes place on a specified date in the future, at pre-agreed price, which is decided on the day of entering into contract. Both parties has obligation to fulfill the terms of contract on the agreed settlement date.
Major differences between Futures and Forwards.
- Futures contracts are exchange-traded and, therefore, are standardized contracts. Forward contracts, on the other hand, are private agreements between two parties and are not as rigid in their stated terms and conditions. Because forward contracts are private agreements, there is always a chance that a party may default on its side of the agreement. Futures contracts have clearing houses that guarantee the transactions, which drastically lowers the probability of default to almost never.
- For forward contracts, settlement occurs towards the end of the contract. But futures contracts are marked-to-market daily, which means that daily changes are settled day by day until the end of the contract. Furthermore, settlement for futures contracts can occur over a range of dates. Forward contracts, on the other hand, only possess one settlement date.
- Because futures contracts are quite frequently employed by speculators, who bet on the direction in which an asset’s price will move, they are usually closed out prior to maturity and delivery usually never happens. On the other hand, forward contracts are mostly used by hedgers that want to eliminate the volatility of an asset’s price, and delivery of the asset or cash settlement will usually take place.