Forward contracts are often confused with futures contracts. The confusion is primarily because both serve essentially the same economic functions of allocating risk in the probability of future price uncertainty.
However futures have some distinct advantages over forward contracts as they eliminate counterparty risk and offer more liquidity and price transparency.
However, it should be noted that forwards enjoy the benefit of being customized to meet specific client requirements.
The advantages and limitations of futures contracts are as follows:
Advantages:
- Price transparency.
- Elimination of Counterparty credit risk.
- Access to all types of market participants. The OTC market is restricted to Authorized Dealers (banks which are licensed by RBI to deal in FX), individuals and entities with forex exposures. Retail speculators with no exposure to FX cannot trade in OTC market.
- Generally speaking, futures offer low cost of trading as compared to OTC market.
Limitations:
- The benefit of standardization, though improves liquidity in futures, leads to imperfect hedge since the amount and settlement dates cannot be customized.
- While margining and daily settlement is a prudent risk management policy, some clients may prefer not to incur this cost in favor of OTC forwards, where collateral is usually not demanded.