When interest rate changes are negatively correlated with the price changes of the asset underlying a futures/forward contract: A) forward prices are higher. B) futures prices are higher. C) futures prices may be higher or lower depending on the risk-free rate and price volatility. Hopefully that was enough room not to bias anyone’s choice. Your answer: B was incorrect. The correct answer was A) forward prices are higher. A negative correlation between asset price changes and interest rate changes makes the mark-to-market feature unattractive to a futures buyer. This leads to a lower futures price, compared to the forward price on an otherwise identical contract. Could someone explain why the mark-to-market feature would be unattractive for a futures buyer? Does this only apply for a typical bond? I was under the (incorrect) assumption that marking-to-market was a good thing for investors…reduces the default risk…
mark-to-market is good if there is a positive correlation between rfr and underlying and bad if there is a neg correlation (futures only – forwards are the inverse) There’s an explanation in the books, but I remember that I’m POSITIVE about the FUTURE and hence positive correlation are futures and neg correlation are forwards.
the m2m fund earns a tiny bit of interest
So suppose your asset and the interest rates are positive correlated (interest rates go up, assets go up). So if you are long some asset and it goes up in value, when it is marked-to-market, you will receive more cash in your margin account. You can take this cash and invest it in a higher interest rate environment (high reinvestment rates). As Dan mentioned, the tiny bit of interest arrives from the little bit of cash that gets deposited in your account at the end of the day. Conversely, if the asset value drops and suppose that there is a margin call, you can borrow money at a lower rate (again because of positive correlation). This is valuable to the futures contract so it will be more expensive than a comparable forward. For negative correlation (like a bond). If interest rates go down, the value goes up, which is bad because you will need to reinvest the marked-to-market money in lower interest rates. Conversely, if the bond price declines interest rates go up, and if you are margin called, you’ll need to borrow money in high interest rate environments. This will make a forward more attractive.
^^^ This is correct. The key is understanding that futures are marked to market daily, and any gain on that day is deposited as cash in your margin account for you to potentially invest in an interest yielding mmkt/whatever. If asset prices are positively correlated with interest rates, then futures are preferable to (i.e. their prices will be higher than) futures: each day’s gain will be paid to you in cash, which you can reinvest at increasing rates.
AliMan - terrific explanation…one less thing I’ll have to memorize now!
Great explanation Aliman You posts are always insightful and relate the theory with Fin mkts practice. Cheers