Futures

Quick Answer

Futures are standardized, exchange-traded contracts that obligate both the buyer and the seller to perform. A clearinghouse guarantees every trade, and gains and losses settle daily through margin accounts. Forwards are the private, customized alternative: no clearinghouse, no daily settlement, and real counterparty risk.

Futures and forwards both lock in a future price today, but the exam rewards knowing exactly where they diverge. Everything below traces back to one fact: futures have a clearinghouse standing between the two sides, and forwards do not.

What Is a Futures Contract?

A futures contract is a standardized, exchange-traded obligation to buy or sell an asset at a predetermined price on a future date.

Key characteristics:

Standardized: The exchange specifies contract size, delivery months, last trading day, and delivery specs; nothing is negotiable.

Exchange-traded: Traded on regulated exchanges (e.g., CME Group); highly liquid.

Obligation, not a right: Both buyer and seller are obligated to perform (unlike options, where only the seller is obligated).

Clearinghouse: Interposes between buyer and seller after trade match, eliminating counterparty risk.

High leverage: Small margin deposit controls a large contract value.

Settlement: A position can be offset (closed out) before delivery by entering an opposite trade on the exchange.

Regulation: Ordinary commodity and broad-based stock-index futures are regulated by the Commodity Futures Trading Commission (CFTC).

Security-futures exception: Single-stock and narrow-based stock-index futures are securities jointly regulated by the CFTC and the Securities and Exchange Commission (SEC).

Common underlying assets:

Commodities: agricultural (corn, wheat, soybeans), energy (crude oil, natural gas), metals (gold, silver).

Financial: stock indexes (S&P 500), interest rates (Treasury bonds), currencies (euro, yen).

Think of it this way: With options, only the buyer decides whether to exercise. The seller might never have to do anything if the option expires worthless. With futures, both parties have signed a binding contract. When expiration comes, the buyer must buy and the seller must sell.

Exam Tip: Gotchas

Both buyers and sellers of futures have obligations. Option buyers have rights, not obligations. This is the key distinction between options and futures/forwards.

How Does Futures Margin Work?

Futures margin works differently from stock margin. It is a performance bond, not a loan. Both the buyer and the seller post it to secure their obligations, and no interest is charged. Accounts settle daily through mark-to-market: gains and losses are credited or debited each trading day.

Exam Tip: Gotchas

Futures margin is a good-faith performance deposit, not a loan. No interest is charged on futures margin. Unlike stock margin (which is a loan from a broker), futures margin is simply a deposit posted by both parties.

What Is a Forward Contract?

A forward contract is a private, customized over-the-counter (OTC) agreement to buy or sell an asset at a specified price on a specified future date.

Key characteristics:

OTC (not exchange-traded): Privately negotiated between two parties.

Fully customizable: Contract size, delivery date, location, and asset quality are all negotiable.

No daily settlement: No mark-to-market; contract settles only at maturity.

No margin requirement: No performance bond; parties may negotiate collateral privately.

Counterparty risk: No clearinghouse means each party bears the risk that the other defaults.

Illiquid: No secondary market; difficult to exit before maturity.

Largely unregulated: Not subject to CFTC exchange rules.

Think of it this way: A forward contract is like a handshake deal. You agree on terms privately, and everything is flexible. But if the other person walks away on delivery day, there is no clearinghouse to step in and make good on the deal. That counterparty risk is the trade-off for the flexibility.

What Are Forward Contracts Used For?

The most typical use of a forward is hedging: locking in a price or rate today for a transaction the business already knows it must make later.

Currency: A multinational that must convert foreign currency in six months fixes the exchange rate now.

Commodities: A manufacturer that needs wheat in three months fixes the purchase price now.

Customization is what makes a forward a good hedging tool. The two parties can match the exact amount, date, and delivery location of the real need, which a standardized futures contract may not fit.

A forward can also express a speculative view, but its features make it a poor tool for short-term trading. There is no secondary market, no daily settlement, and each side carries the other's default risk. Traders who want to move in and out of a position quickly use exchange-traded futures, which an offsetting trade closes.

Exam Tip: Gotchas

"Locking in a future price or rate" points to a hedge; "short-term trading" points to futures. A forward can be used to speculate, but it is difficult to exit before maturity, so it is a poor fit for a day trader.

How Do Futures and Forwards Compare?

This comparison is frequently tested.

Traded on: Futures Regulated exchange; Forwards OTC (private).

Terms: Futures Standardized; Forwards Fully customizable.

Counterparty risk: Futures Eliminated (clearinghouse); Forwards Present (no intermediary).

Daily settlement: Futures Yes (mark-to-market); Forwards No (settled at maturity).

Margin required: Futures Yes (performance bond); Forwards No.

Liquidity: Futures High; Forwards Low (no secondary market).

Regulation: Futures CFTC-regulated; Forwards Largely unregulated.

Transparency: Futures Public pricing; Forwards Private pricing.

Exam Tip: Gotchas

Futures eliminate counterparty risk; forwards do not. The clearinghouse is the key difference.

Forwards are OTC and customizable; futures are standardized and exchange-traded. If the exam describes a "customized, privately negotiated agreement," it is a forward.

What Should You Check on Exam Day?

Both parties on a futures or forward contract are obligated to perform; only option buyers hold a right instead of an obligation.

Futures are exchange-traded and standardized; forwards are OTC and fully customizable. The clearinghouse is what eliminates futures counterparty risk. Forwards keep that risk because no clearinghouse guarantees them.

Futures margin is a good-faith performance deposit, not a loan, and carries no interest. Futures settle daily through mark-to-market; forwards settle once, at maturity.

The most typical forward use is hedging: a business locks in a price or rate for a known future need, such as a company fixing an exchange rate. Short-term trading is a futures use.

Ordinary commodity futures fall under CFTC jurisdiction. Single-stock and narrow-based stock-index futures are securities under joint CFTC and SEC oversight.