Investing 101: What is a forward/futures contract, and how are they different?

June 12, 6:00 PMBusiness and Finance 101 ExaminerAndy Samuels

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A forward or future is a contractual agreement between two parities where one agrees to buy, and the other sell, an asset at an agreed upon later date. They are a type of derivative security.

Here is how they work:

If Seth wants to sell his house a year from now, and Mark wants to buy a house a year from now, the two can engage in a forward contract. If Seth’s house is worth, say, $1 million at that time, they can agree that Seth will sell the house to Mark for $1.04 million a year from now. Mark is betting that the house would have been worth more than that one year from now, and Seth is betting that the house will be worth less than that one year from now, or he wants the security of knowing that his house will be sold and is willing to overlook potential profits for that piece of mind.

The price that the two parties agree upon in the futures/forward contract is referred to as the forward price. The price of the asset when it changes hands at that future date is referred to as the spot price. The difference between the forward and spot prices is the profit, or loss, depending upon which side you view it form, the buyer’s or seller’s.

Forwards and futures are used to hedge risk, as a vehicle for speculation, or allow the buyer to capitalize on a time-sensitive aspect of the underlying asset.

Forwards are very similar to futures contracts, but they do differ in a few regards. For example, futures are regulated contracts that trade on an exchange, whereas forwards are typically private agreements.