The limitations of forwards contracts are:
1. Liquidity risk:
Liquidity is the seamlessness with which market participants can buy or sell their desired quantity of the underlying asset at their desired price. Forwards are personalized private contracts which have specific requirements from the parties involved. Hence, other participants may not trade this contract.
Forwards are also not listed on exchanges which makes it less accessible to other market participants. These two factors make it illiquid.
Therefore, it is very difficult for parties to exit from a forward contract before the contract's maturity.
2. Counter-party risk:
This risk exists in the possibility of the failure of counter-party to fulfill its contractual obligation which could lead to a monetary loss.
A and B enter into a bilateral agreement, where A will purchase 100kg of rice at Rs.20/kg from B after 6 months. Here, A is B's counterparty and vice-versa.
After 6 months, if price of rice is Rs.30 in the market then B may forego his obligation to deliver 100 kg of rice at Rs.20 to A. Also, if price of rice falls to Rs.15,
then A may purchase from the market at a lower price, instead of going through with the contract. Thus, a party to the contract may default on his obligation if there is incentive
to default. This is also called default risk/credit risk.
3. There are also issues like lack of transparency, settlement complications as it is to be done directly between the contracting parties.
Futures contracts eliminate these risks by bringing these contracts to a centralized trading platform.