Explanation
Forward contracts differ from futures contracts in several key ways:
Key Differences:
- Trading Venue: Forward contracts are traded over-the-counter (OTC), meaning they are privately negotiated between two parties, while futures contracts are traded on organized exchanges.
- Standardization: Futures contracts are standardized in terms of contract size, delivery dates, and other specifications, whereas forward contracts are customizable to meet the specific needs of the parties involved.
- Marking to Market: Futures contracts are marked to market daily, meaning gains and losses are settled each trading day. Forward contracts typically settle only at maturity.
- Counterparty Risk: Forward contracts have higher counterparty risk since they are not cleared through a central clearinghouse, unlike futures contracts.
Why Option C is Correct:
- Forward contracts are indeed traded over-the-counter, which is one of their primary distinguishing characteristics from exchange-traded futures.
Why Options A and B are Incorrect:
- Option A (standardized): This describes futures contracts, not forwards. Forwards are customizable and non-standardized.
- Option B (marked to market): This is a feature of futures contracts, not forwards. Forwards typically settle only at contract maturity.
Additional Context:
- The OTC nature of forwards allows for greater flexibility in contract terms but comes with higher counterparty risk.
- Futures contracts' standardization and exchange trading make them more liquid and transparent than forwards.
