If there is a direct relationship with futures prices and interest rates, futures are priced higher than forwards. Isn’t the price of a futures contract set at the beginning of the contract?
Also, I’ve seen explanations of this based on what happens when the underlying moves. So, can someone explain this in terms of the futures price moving (not the underlying). If the reasoning is that as the underlying moves up a long futures contract (at expiration) will be more valuable, it still doesn’t make sense with respect to price.
My confusion is that since the futures price is set at the outset, why is the price sensitive to interest rates?
If the underlying price of a non-dividend (interest) paying and non-storable asset is S0 = $100, and the annual risk-free rate, r, is 5%, assuming that the one-year futures price is $107, we can show that this situation creates an arbitrage opportunity and the trader can use this to earn risk-free profit. The trader can implement following actions simultaneously:
Borrow $100 at a risk-free rate of 5%.
Buy the asset at spot market price by paying borrowed funds and hold.
Sell one-year futures at $107.
After one year, at maturity, the trader will deliver the underlying earning of $107, will repay the debt and interest of $105 and will net risk-free of $2.