Forward and Futures Trading Mechanism

Forward Contract Trading:

Negotiation: Two parties (e.g., a buyer and a seller) directly negotiate the terms of the contract. This can be done through a dealer or broker, or directly between the parties.
Agreement: Once terms are agreed upon, the contract is legally binding.
Settlement: At the settlement date, the parties fulfill their obligations.
- Physical Delivery: The seller delivers the underlying asset to the buyer, and the buyer pays the agreed-upon forward price.
- Cash Settlement: Instead of physical delivery, the difference between the forward price and the market price at settlement is paid in cash.

Futures Contract Trading:

Order Placement: A trader places an order to buy or sell a specific futures contract through a broker who is a member of the relevant exchange.
Matching: The exchange's electronic trading system matches buy and sell orders based on price and time priority.
Clearinghouse Intervention: Once a trade is executed, the clearinghouse becomes the counterparty to both the buyer and the seller.
Margin Account: Both the buyer and seller must have a margin account with their broker. Initial margin is deposited when the position is opened.
Daily Marking-to-Market: At the end of each trading day, the contract is marked-to-market. Gains or losses are credited or debited to the margin accounts based on the change in the futures price.
Margin Calls: If the margin account balance falls below the maintenance margin level, the trader receives a margin call and must deposit additional funds to bring the balance back up to the initial margin level.
Offsetting or Delivery:
- Offsetting: Most futures contracts are closed out before maturity by taking an offsetting position. For example, if a trader initially bought a futures contract, they would sell an identical contract to close their position. Any net gain or loss is realized through the margin account.
- Delivery: A small percentage of futures contracts result in physical delivery of the underlying asset. The delivery process is specified by the exchange.