InvestorQ : I understand futures and forwards are similarly products. Then why are they trading as separate products?
manisha Kolvenkar made post

I understand futures and forwards are similarly products. Then why are they trading as separate products?

Mahima Roy answered.
2 years ago

You are right that conceptually both futures and forwards are the same. But scratch the surface and there are important differences between the two. Here is how.

Futures are traded on a recognized stock exchange but forwards are over the counter products. OTC contracts are typically executed over the telephone. For example, if a large importer wants to hedge dollar risk then they will approach the bank. The bank will, in turn, talk to another bank and get a forward deal signed up. Futures are traded on the exchange and therefore they are more liquid. In a stock exchange there are large number of buyers and sellers and the price discovery also happens through a very transparent market mechanism.

Futures are standardized products whereas forwards are customized to specific and unique requirements. If you take the Nifty futures they are cash settled only. Secondly, the lot sizes of Nifty futures are standardized. Thirdly, the expiries are standardized. You can either have a 1 month, 2 month or 3 month contracts only, nothing else. Lastly, they are standardized in terms of the underlying assets. The underlying has to either be an index or a specific stock. When contracts are standardized, they automatically become liquid because the universe of options is limited. In the case of forwards, the liquidity is a major challenge. For example, if you get into a forward contract and want to exit midway then the only hope is that someone with a similar requirement also turns up.

Futures are relatively safer and more secure compared to forwards due to the counter guarantee given by the clearing corporation of the exchanges. The dollar forward contract has not counter guarantee but players in this market are typically the large banks and financial institutions and hence the risk of default is ruled out. But there are many forward contracts that are outside the banking channel. Here the risk is real. If one party defaults on its commitment, the other party only has a legal recourse under the Indian Contracts Act and the resolution can take a long time. This problem is resolved in futures through the clearing corporation mechanism. When you trade in the futures market, every trade carries counter guarantee by the clearing corporation of the exchange. For example, when X buys 5 lots of Nifty futures and Y sells 5 lots of Nifty futures, then both of them are actually placing the trade through the NSE Clearing Corporation (NSCCL). The NSCCL actually is the counterparty to both the trades. If one of the party defaults then the NSCCL will honour the trade and then initiate recovery from the other party. This can effectively prevent payment crises in the futures markets, unlike in forward markets.