If Champion thinks that the S&P 500 index is negatively correlated with interest rates, then choosing the short forward contract over the short futures contract is: A) counterproductive because a short futures contract would benefit more from a higher borrowing rate. B) counterproductive because a short futures contract would benefit more from a higher reinvestment rate. C) appropriate because the forward contract would benefit more from a higher reinvestment rate. Explanation References When hedging a position, futures contracts are better if the hedge produces a positive cash flow, via marking-to-market, when interest rates rise and is hurt when interest rates fall. In this case, when interest rates rise and cause equity values to fall, a short futures position will receive a positive cash flow that can be reinvested at the higher rate. If interest rates fall, and the short futures position must be marked to market with a negative cash flow, the opportunity cost of the negative cash flow is lower. Forward contracts that do not require marking-to-market do not “benefit” from changes in interest rates. This one is quite confusing because as per LOS 48.c if interest rates and assets are positive correlated; futures will get higher prices than forwards; hence in this case a forward contract will be more appropriate given the inverse correlation… Could you explain me why C is not the right answer? thanks S
Suppose S&P goes up, so interest rates go down.
You’re short, so you lose value.
If you have an S&P futures contract, you lose money in your margin account.
However, you lose less interest on the money you lost because rates are lower.
Not so bad.
Suppose S&P goes down, so interest rates go up.
You’re short, so you gain value.
If you have an S&P futures contract, you gain money in your margin account.
Not only do you gain money, but you get higher interest on the money you gain.
Doubly good.
You get none of this with the forward contract, as there’s no margin account.
Wow, yeah, that makes sense.
I am a little scared to this type of question in the exam…
I think I am answering them in a CFA1 style!
Thank you so much for the reply!
You’re quite welcome.