Forward vs Futures: Same Payoff, Different Plumbing

A forward contract and a futures contract oblige the same thing and pay the same amount at the same settlement price. The two differ only in the plumbing. Nobody stands between the two sides of a forward, all of its money moves on one day, and nothing is lodged. A clearing corporation stands between the two sides of a future, money moves daily, and both sides lodge collateral.

Once two parties have agreed a price for a later date, the obligation itself is finished business. Neither of them can improve it, walk away from it or renegotiate it. Everything still open is an arrangement around that obligation, and every difference in this guide is an answer to one narrow question: what happens in the stretch between the day the price was agreed and the day the money actually moves.

Two sides are named the same way throughout this guide. On the bilateral agreement they are the forward buyer and the forward seller. The two wrote the terms together, so each of them knows exactly who the other one is. On the cleared arrangement they are the long position and the short position. A clearing corporation has stepped into the middle, so neither of them knows who the other one is or has any reason to find out. Whichever pair is in view, the binding starts the instant a number is settled between them, and it binds each of the two equally. Neither side is holding a choice, a right or an entitlement, and neither can decline on the day.

One more thing settles every figure below, so it comes before the mechanism. The reference asset used throughout has a price for delivery now of Rs 2,000.00/-, and it hands its holder nothing across those twelve months. There is no coupon, no rent and no distribution anywhere in this arithmetic. The absence of any payment is not a simplification made to keep the sums tidy. A payment during the holding period would move the agreed price on both arrangements, so the absence is stated rather than left to be assumed.

What is a forward contract, for a reader meeting one for the first time?

Two parties sit down and settle three things between themselves in one conversation: a quantity of the reference asset, a date some months out, and the number one of them will hand over to the other when that date arrives. Those three things are the whole of it. There is no third party in the room, no venue, and no form to fill in beyond the one they write between themselves. Every term is negotiated: the quantity, the date, the place, what counts as delivery, and what happens if something goes wrong.

Nothing is paid to enter a forward contract, so on the day it is struck no money has moved at all. This trips up almost everybody who arrives from shares, where buying means paying. Here, agreeing means agreeing. The forward buyer has not bought anything yet and the forward seller has not been paid anything yet. The forward on day one is a promise with a date on it and a number on it, and nothing else.

Think of a caterer and a rice wholesaler in the week after a wedding season ends. The caterer knows they will need six hundred kilos next November and would rather not find out in November what it costs. The wholesaler would rather not find out either. The two agree a price today for a November handover, shake on it, and both walk away with no money having changed hands. Neither of them can back out in October because the price moved against them. The handshake is a forward contract, and happening over a counter rather than on a screen changes nothing about what it obliges.

The price they agree is not a guess about November. Put Rs 2,000.00/- down and let financing at 6.50 per cent a year run against it for twelve months. Financing attaches Rs 130.00/-. The agreed price stands at Rs 2,130.00/-. Rs 2,130.00/- is what somebody spends to acquire the reference asset now on borrowed funds and carry it right through to the date. Not a rupee arrives from the reference asset in the meantime, so nothing comes in against the financing along the way.

Notice the three terms the formula leaves out. There is no term for what anybody thinks the price will be in a year, no term for how far it might travel, and no term for how likely any of that is. The agreed price is arrived at by multiplication, and a multiplication cannot hold an opinion.

What is a futures contract, and what changes when an exchange writes the terms?

A futures contract obliges exactly the same thing. One side must take delivery when the date comes round and pay the number settled at the start, the other must hand the reference asset over and accept that number, and neither can decline. The difference lies in who wrote the terms and who sits between the two of them afterwards.

Every term except the price is fixed in advance by an exchange. The quantity one contract stands for, the date it runs to, what has to be delivered and how, the calendar the dates follow, all of it is decided before either side arrives. The only thing the two sides settle between them is the number. And the moment they settle it, a clearing corporation steps into the middle and becomes the buyer facing the seller and the seller facing the buyer, so what each side actually holds afterwards is a position against the middle rather than against a named person.

Both sides of a futures contract are bound in precisely the way both sides of a forward contract are bound, and nothing about standardisation loosens that. A standard form is not a softer promise. The standard form carries the same promise, written once for everybody instead of once for each pair.

The nearest everyday thing is a ticket counter. When a shop sells a numbered ticket for a bus that leaves at a fixed hour, nobody negotiates the seat width or the departure time; those are decided before anybody queues. All that is left to settle is the fare. And because every ticket for that bus is written identically, one passenger's ticket and the ticket held by the person behind them are the same object. Identical tickets are the property that makes the whole arrangement work later on.

The terms the exchange fixes are real and they matter. The quantity one contract stands for, the dates it trades to, how quickly money and the referenced thing move once a trade is done, and who is permitted to carry a position at all, are settled by the Securities and Exchange Board of India (SEBI), whose framework the exchanges and clearing corporations operate under, at sebi.gov.in. Every one of those differs by contract and is revised. Naming the authority is worth more here than a figure that would be false on revision day.

Do the two pay the same amount at the same settlement price?

They do, and settling that first matters. A reader who half suspects the payoffs differ will read all four differences as though they were about money and get every one of them wrong.

Take one unit, an agreed price of Rs 2,130.00/- on both arrangements, and run three settlement prices through each. At Rs 2,400.00/- the side bound to buy is getting the reference asset for Rs 2,130.00/- when it is worth Rs 2,400.00/-. The gain is plus Rs 270.00/- on the bilateral agreement and plus Rs 270.00/- on the cleared one. At Rs 1,600.00/- that same side is bound to pay Rs 2,130.00/- for something worth Rs 1,600.00/-. The loss is minus Rs 530.00/- on both. And at an unchanged Rs 2,000.00/-, where the reference asset finishes exactly where it started, it is minus Rs 130.00/- on both.

The two arrangements produce one number and not two, so there is nothing to compare on outcome. The single number governs the rest of the comparison. Any treatment that ranked a forward against a future on results would be ranking a figure against itself, and would be wrong for a reason that has nothing to do with taste.

The third row is the one worth stopping on, and it is where a comparison can quietly do damage. Tested from both ends, the forecast reading falls apart at each. A settlement price landing dead on Rs 2,130.00/- pays the long side nil, so a prediction that came true to the rupee would have earned exactly nothing. At the other end, suppose nothing whatsoever happens and the twelve months close on Rs 2,000.00/-, the very number they opened on. The long side is handed minus Rs 130.00/-. The figure is the financing and nothing besides. A number that pays nil when its supposed forecast is correct, and takes Rs 130.00/- when nothing at all happens, is not describing anybody's view. The agreed price is a cost.

Which of four kinds is any given figure?

Three of the four kinds appear here and they are not interchangeable, so asking which kind any figure is, is a habit worth having. Rs 2,000.00/- is a PRICE, and so is Rs 2,130.00/-. A PREMIUM is what somebody pays to acquire a position, and none appears anywhere here. Nothing at all is paid to enter either arrangement, and the absence is worth stopping on rather than skipping past. Plus Rs 270.00/- is a PAYOFF, meaning what the position throws off at settlement before anything paid to get there is deducted. And because nothing was paid to get there, that same plus Rs 270.00/- is also the PROFIT. The two coincide here because of how these two contracts are entered, not because they are generally the same thing.

Quantities get the same treatment. Take forty contracts at the agreed price of Rs 2,130.00/-. Multiply, and Rs 85,200.00/- of notionalWhat a contract is written over, arrived at by multiplying quantity by price. The notional scales the sums and never leaves anybody's account. comes out, not a rupee of which has left anybody. Now take those same forty units, valued instead at Rs 2,000.00/-, the price of the reference asset for delivery now. Multiply again, and Rs 80,000.00/- of exposureThe value a position actually rides on, taken at today's price for the referenced thing rather than at the number written into the contract. comes out. The collateralCash or assets lodged so a promise has something standing behind it, handed back once the promise is discharged. gets sized against that figure. Two figures, both correct, both about the same forty contracts, and a reader who blurs them has a position that looks either six per cent bigger or six per cent smaller than the one they are actually carrying.

Who stands between the two parties, and what does that change?

On the bilateral agreement, nobody. Each of the two is exposed to one particular party, named on the paper they wrote together, for as long as the arrangement runs. Should that party be unable to perform when the final date comes round, what the agreement turns out to have been worth is whatever the party was worth. Not the reference asset, not the arithmetic, and not the fairness of the price. That party.

On the cleared arrangement, the clearing corporation. The moment the price is agreed, it becomes the counterpartyWhoever sits opposite a party in an agreement and has to perform before that party sees anything. to both sides, so the long position faces the middle and the short position faces the middle and neither of them faces the other. Most participants reach that middle through a clearing memberThe firm that faces the middle directly, so a participant reaches the clearing corporation through it rather than on its own account. rather than directly, and how a clearing corporation is funded, governed and capitalised is covered separately.

The practical consequence is not the category, it is the exit: on one arrangement closing means going back to the same person, and on the other it means dealing with anybody at all.

One principle behind this arrangement travels further than India. Principles for cleared markets that cross borders are the province of the International Organization of Securities Commissions (IOSCO), iosco.org, and the rule binding anybody operating in India is SEBI's version of them, at sebi.gov.in.

When does the money actually move, and does the timing change the total?

On the bilateral agreement, once, at the end, and nothing whatsoever in between. Two parties agree a price in January and nothing happens in February, March or October. On the cleared arrangement, every day, in both directions, against the collateral balance each side has lodged.

The total that changes hands is identical on the two arrangements and only its timing differs, and that is worth proving rather than asserting. Follow a two day path. The agreed price is Rs 2,130.00/-. At the close of the first day the contract stands at Rs 2,110.00/-, and at the close of the second it stands at Rs 2,150.00/-.

On the cleared position, Rs 2,110.00/- less Rs 2,130.00/- is minus Rs 20.00/-, so day one moves minus Rs 20.00/- against the long side. Rs 2,150.00/- less Rs 2,110.00/- is plus Rs 40.00/-, so day two moves plus Rs 40.00/- to the long side. The two daily amounts add to plus Rs 20.00/-. On the bilateral agreement nothing moves on either day. At the end the long side receives Rs 2,150.00/- less Rs 2,130.00/-, or plus Rs 20.00/-. Same figure. One route reached it in two payments and the other reached it in one.

The collateral balance on the cleared position tells the same story from the side of the account. The balance opens at Rs 160.00/-, day one takes Rs 20.00/- out of it and leaves Rs 140.00/-, day two puts Rs 40.00/- into it and leaves Rs 180.00/-. Nobody has paid a fee and nothing has been consumed; a balance has moved down and then up by exactly the amounts the contract moved.

Underneath sits an arithmetic so ordinary that it is easy to miss. Each day the cleared position settles the difference between today's price and yesterday's. String those differences together and every intermediate price cancels against itself, leaving only the last price and the first one.

Now the consequence, and it is the reason the whole arrangement was built. The amount owed on a cleared position is collected while it is small, so it never accumulates. On the bilateral agreement nothing is collected, so the amount one side will owe the other simply grows as the reference asset travels away from Rs 2,130.00/-, and it is at its largest on precisely the day somebody has to find it.

A household version makes the shape obvious. Two neighbours share a borewell pump and split the electricity between them. One pays their share every month as the bill arrives; the other lets it run and settles at Diwali. Both pay the same amount over the year. But on any given day in August, one of them is owed a few hundred rupees and the other is owed several thousand, and only one of those two is exposed to the neighbour losing their job in September.

What is lodged before anything moves?

On the bilateral agreement, nothing. No cash leaves either side before the final date, and nothing stands behind the promise except the promise. The absence of collateral is not sloppiness but what the two parties agreed to, and it is why the arrangement costs nothing to carry.

On the cleared position, both sides lodge initial margin before the position is carried at all. On the figures used here that is Rs 160.00/- a side against Rs 2,000.00/- of exposure, or 8.0 per cent. The 8.0 per cent is a teaching figure and not a requirement. Real margin is worked out by clearing corporations under SEBI's framework at sebi.gov.in, it differs by contract and by day, and it moves. A further demand can also arrive part way through a trading day, and whether, when and how that intraday margin callA demand for further collateral raised part way through a trading day rather than after it closes. is raised is settled by the same authority.

Rs 160.00/- on its own means very little, and Rs 2,000.00/- on its own means very little, so print them together. Rs 2,000.00/- of exposure standing on Rs 160.00/- of collateral is 12.50 times. The ratio of 12.50 times is what makes a cleared position a different thing to hold from an equivalent amount of the reference asset itself, and quoting either figure without the other one beside it misleads in opposite directions.

Both consequences are worth stating and neither is worth ranking. Lodging nothing costs nothing to carry and leaves the promise with nothing behind it. Lodging collateral ties up cash that could have been doing something else and puts something behind the promise. The two consequences have the same shape. Calling either one the sensible choice would need a judgement about a party nobody has met.

How does a party get out before the date, and why is that the hardest difference?

Getting out is the fourth axis, and it falls straight out of the first one. Who stands between decides what getting out looks like, and the two answers are not variations on a theme.

On the bilateral agreement there are two routes and neither is comfortable. The first is to go back to the same party and agree to unwind the arrangement. Unwinding requires their agreement, and they are under no duty to give it. The agreement may have moved in their favour and cancelling it costs them something, so they may want a payment, or they may simply say no. The second route is to strike a fresh agreement with somebody else that faces the other way. A second agreement neutralises the money, but the first agreement is still standing, the first party is still on the other end of it, and now there is a second party on the other end of the second one. The exposure to somebody not performing has gone up, not down.

On the cleared position there is one route. Every contract of that description is identical to every other one, so taking the opposite position in the same contract cancels the two outright. The obligation to buy and the obligation to sell are against the same middle, in the same instrument, and there is nothing left standing once they meet. Interchangeability is what standardisation was for, and it is the payoff for giving up the ability to negotiate the terms.

Interchangeability is also why a running count of positions still standing means something on one arrangement and almost nothing on the other. Where every contract is identical, open interestA count of the positions still standing at the end of a day, neither closed out nor settled. can be counted at the close of a day and published; where every agreement is written separately between two named parties, there is no common object to count. Open interest is covered separately.

What does each arrangement cost, and what does each one buy?

Everything above can be reread as a trade in both directions.

The bilateral agreement buys an exact fit. The precise quantity somebody needs, the precise date they need it, delivered where they need it. A caterer who needs six hundred kilos on the eleventh of November can have exactly that, and nobody is offering a contract for five hundred kilos on the last Thursday of the month. The exact fit costs the whole of the other party's ability to perform, it costs the inability to hand the arrangement on to anybody, and it costs a running debt that nobody trims at any point before the day it has to be settled.

The cleared position buys a promise with something standing behind it and an exit that nobody has to agree to. The quantity and the date were decided before either party arrived, so the cleared position costs an approximate fit. It costs cash tied up as collateral, doing nothing else. And it costs cash moving on days nobody chose, which is a real constraint rather than an inconvenience. A party can be entirely right about the final date and still be unable to fund the fourteenth of the month.

Neither list outweighs the other, and the reason is not delicacy. Weighing them needs two facts that live with a reader and not with a contract: what the position exists to do, and what is already held against it. Change either one and the same two lists come out the other way round.

Four fields on one sheet, and who fills each one in

A single internal sheet carries four blank fields, the kind that gets filled in before a position is allowed to stand overnight. Somebody different fills in each field, and the four fields ask exactly the four questions set out above. The four fields are the practical shape of the whole comparison, and they are more use than any list of advantages.

The household version of the same four fields is a chit arrangement with the neighbour opposite, against a deposit lodged at a housing society office. With the neighbour, field one has a name in it, field two has one date, field three is empty and field four says the two parties will have to talk. With the society office, field one has an institution in it, field three has a receipt number, and field four says produce the receipt. Neither arrangement is the better one. The two are different arrangements, and which one anybody should be in depends on facts about that party rather than on anything a general treatment holds.

Why neither arrangement is ranked above the other

A comparison is usually expected to end in a verdict. There is not one here, and the reason is worth more than the verdict would have been. Ranked on what they produce, the two are plus Rs 270.00/- against plus Rs 270.00/-. Ranked on anything else, four facts would be needed that no general treatment can hold: what the position exists to do sits with whoever is taking it, what is already held against it sits on their own books, what has been lodged sits in their own cash, and what the settlement morning will demand of them depends on all three of those together. Not one of those is a property of a contract.

A flatter reason sits underneath that one. Neither arrangement has a performance to rank. Both produce the settlement price less the agreed price, and that subtraction holds no track record, no distribution and no probability. Naming one of them the better performer would mean describing a difference of nil. Understanding how each arrangement is wired is not a reason to enter either.

One more thing that seldom gets said out loud. Neither arrangement removes anything. Both of them fix a price, and fixing a price means giving up the good outcome along with the bad one. The side bound to buy at Rs 2,130.00/- is just as bound when the settlement price is Rs 2,400.00/- as when it is Rs 1,600.00/-, and in the second case they are paying Rs 2,130.00/- for something worth Rs 1,600.00/-. There is no version of either contract in which somebody gets to look at the settlement price first.

What settles when the final date arrives?

On both arrangements the obligation runs out at the same place. The side bound to buy pays and takes, the side bound to sell delivers and is paid, and whether that happens through physical deliverySettlement in which the referenced thing itself moves between the two sides, instead of a cash difference being paid. or through a cash difference is a term of the contract rather than a difference between the two kinds. Which contracts deliver the referenced thing, which settle in cash, and how long either takes, are settled by SEBI at sebi.gov.in, and what happens on that final date is covered separately.

Only one thing is worth carrying away. On the cleared position, by the time the final date arrives, almost all of the money has already moved. The daily amounts have been collected as they arose and what is left is the last one. On the bilateral agreement, on that same morning, none of it has moved and all of it still has to. Two identical obligations, two identical totals, and two mornings that do not feel remotely alike.

The reference asset, the contracts and the parties in this comparison are invented.
Educational material. Not advice on any investment, tax, budget or market position.