A forward contract is much like a futures contract in that it is an agreement for the future delivery of some amount of something at a specified price and at a specified time in the future.

Sounds exactly the same in fact; but there are a number of important differences

Standardisation

The first important distinction is that futures contracts are standardised agreements traded on exchanges, whereas forward contracts are non-standardised contracts negotiated directly between the buyer and the seller. They are, essentially, OTC futures.

Standardisation – in terms of amounts, prices, delivery dates and so on – is important because it creates liquidity. The downside of standardisation is that buyers and sellers do not have the flexibility to negotiate contracts which reflect exactly the positions they want to take.

Settlement

Another important difference is that, although both futures and forward contracts establish terms of delivery – how much, at what price and when – futures contracts are not generally intended to be settled by delivery. In fact, generally less than 2% of futures contracts are delivered or go to final settlement.

However, forward contracts are intended to be held to final settlement – even if they settle in cash rather than delivery of the underlying.

Risk

Finally, both parties in a forward contract are exposed to credit risk because there is a possibility that either party may default.

This risk is almost zero with futures contracts because the buyer and seller are not dealing directly with each other but with the exchange which trades the contract and which – through what is called its clearing house – guarantees both sides of the transaction.