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What Characteristics Distinguish Futures from Forwards?

Futures contracts:

  • are standardized.
  • are traded at the exchange.
  • are rarely settled physically (mostly closed-out).
  • are settled through a clearing house which eliminates the settlement risk by requesting, among other things, collateral from both the buyer and seller.
  • are adjusted on a daily basis to the development of the market price, through a daily settlement of profits and losses. This makes an accumulation of losses impossible.

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With off-exchange forward contracts, traditionally the trading partners must provide and calculate the necessary collateral by estimating the mutual credit risk and potential price fluctuations of the underlying instruments themselves. With exchange-traded futures contracts, the Clearing agency stipulates the amount and type of collateral to be provided.

Individual credit risk evaluation and margining
Clearing house calculates the margin requirements
The clearing house gives a guarantee against the respective clearing members to fulfill all traded contracts.

Nowadays many OTC trades are cleared as exchange trades via central counterparties. In this context, Eurex Clearing offers many services via its EurexOTC Clear. More information can be found here.

In the case of forwards, profits and losses between market participants are only calculated upon settlement of the trade at the end of its term (or rather the trades are settled and profits/losses incurred at this point), whereas profits and losses are calculated on a daily basis for futures contracts (anticipated settlement).

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*Also applicable here: As OTC derivatives are often cleared through clearing houses nowadays, they also get daily margin adjustments. The profits and losses though are not (necessarily) exchanged in cash amongst market participants.Daily offsetting of profit and loss reduces the risk to just one day's change in price.Therefore securities are only compiled for volatility estimated by the clearing house until the next day or for another determined short time frame that the clearing house deems as reasonable. Reasonable can also be a longer time frame that allows the clearing house to settle open positions in case of a default of a clearing member.

Lower margin requirements:
This process is logical as the clearing house does not have information about how long a market participant keeps or when he closes out his position. Securities for the complete futuresā€˜ maturity would be too much for daily closing out possibility.

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