Write a short note on Forwards and Futures.

Forwards vs. Futures

Forwards:

1. Definition: Forwards are private agreements between two parties to buy or sell an asset at a specified price (the forward price) on a future date (the delivery date).

2. Customization: Forwards are highly customizable, with terms such as the underlying asset, quantity, price, and delivery date negotiated between the parties.

3. Trading Venue: Forwards are traded over-the-counter (OTC), meaning they are not traded on a centralized exchange but rather directly between the two parties involved.

4. Counterparty Risk: Since forwards are private agreements, they carry counterparty risk, meaning there is a risk that one party may default on the contract.

5. Settlement: Forwards are typically settled at the end of the contract period, with the delivery of the underlying asset and payment made according to the agreed terms.

Futures:

1. Definition: Futures are standardized contracts traded on regulated exchanges that obligate the buyer to purchase and the seller to sell an asset at a specified price on a future date.

2. Standardization: Futures contracts are standardized in terms of the underlying asset, quantity, quality, and delivery date, making them more uniform and easier to trade.

3. Trading Venue: Futures are traded on centralized exchanges, such as the Chicago Mercantile Exchange (CME), where buyers and sellers are matched by the exchange.

4. Counterparty Risk: Futures are guaranteed by the clearinghouse of the exchange, which acts as the counterparty to both the buyer and seller, reducing counterparty risk.

5. Settlement: Futures contracts can be settled in two ways: through physical delivery of the underlying asset or cash settlement, where the difference between the futures price and the market price is paid.

Key Differences:

1. Customization vs. Standardization: Forwards are highly customizable, while futures are standardized contracts.

2. Trading Venue: Forwards are traded OTC, while futures are traded on regulated exchanges.

3. Counterparty Risk: Forwards carry counterparty risk, while futures are guaranteed by the exchange's clearinghouse.

4. Settlement: Forwards are typically settled by physical delivery, while futures can be settled by physical delivery or cash settlement.

In summary, while both forwards and futures are derivative contracts used for hedging and speculation, they differ in terms of customization, trading venue, counterparty risk, and settlement methods.