Question

When a comparison is made between futures and forwards contracts,it is said that futures are more liquid ,but forwards are more flexible.Explain the meaning of the statement and comment on how difference in contract liquidity and design flexibility might influence an investors preferences in choosing one instrument over the other.

Answer 1

This statement signifies the fundamental features of a futures and forward contracts

We all know that futures are exchange traded contracts because of which they are highly standardised, which means everything in futures contracts for example its maturity lot size per contract, underlying all these will be standardized and price is also determined by the market forces. so if a person needs to purchase $ 3 months from now and there are only two months futures are available then he cannot customize the contract he has change his strategy according to the contract because of having this much standardisation they become more liquid they can be easily bought and sold in derivative exchange.while forward contracts on the other hand are customized we can discuss all the features like maturity period, lot and price, this makes the forward more flexible but less liquid because it is not very easy to exit from the contract unless we find a new party to enter into a reverse contract which nullifies the original contract. But there is one benifit of futures which is, they don't have credit risk because of margin requirements,whareas forward has credit default risk because their is no presence of intermediaries and margins

So if a customer wants customuzation but ready to sacrifice liquidity and ready to bear credit risk then he can choose forward.

But if he wants liquidity with no credit risk then should go for futures.