Financial Help: What is the Difference Between a Futures Contract and a Forward Contract?

Futures contracts are a financial instrument that evolved out of Forward contracts. Historically, farmers, banking institutions and buyers used to negotiate purchase and delivery of a commodity where the banking institution offered a letter of credit to the supplier based on the purchaser's credibility. In turn the farmer would deliver goods on a specified date and was paid by the banker. The banker then settled with the buyer.

Over time commodities exchange process became more sophisticated and the forward contracts themselves were bought and sold without actual delivery of the commodity. Eventually around the middle of the 19th century exchanges emerged in which these contracts were traded in the form of Futures contracts which led to more differences between the two types of contracts. These differences are outlined as follows:

•Regulation: Forward contracts are not regulated in the same as Futures contracts are. Futures contracts are subject to more oversight from organizations such as the Commodity Futures Trading Commission (CFTC).

•Contract Terms: Negotiating a forward contract can be done in a restaurant, at a golf game or at a business meeting. Futures contracts are conducted exclusively through a trading exchange such as the Chicago Board of Exchange.

•Derivative Commodity: While forwards and futures can theoretically trade in anything, in practice Futures are limited to what the exchange incorporates into its trading mechanism. For example, The Chicago Board of Exchange facilitates futures contracts in agricultural, bond futures and metals futures. Forward contracts have more flexibility in what is traded due to the fact they do not have to be traded through an exchange.

•Fees and/or Commission: Futures contracts usually involve some kind of fee and/or commission whereas forward contracts between individuals do not have to incur finance charges.