Forward prices are likely to be lower than futures prices when: A. interest rates are low. B. asset values are positively correlated with short rates. C. asset values are negatively correlated with short rates.
Woah I forget this one… People like futures more when asset prices are positively correlated to short rates, which (wild guess) should drive up futures prices as demand rises, so I’ll say B.
Futures are margined using T-bills and the likes, so when interest rates are up you make money on your T-bills while also gaining on the asset…so if my memory is right, the answer should be B.
B for sure.
I go with C because of the following reason. Please correct me what I am missing here. Bond prices are negatively correlated with interest rate. Say, you sold fixed income bonds(you are short on bond). If the interest rate goes up, bond price will go down. Since you are short on bond, when bond price goes down, you receive money (in case of future contract as opposed to forward) and that money can be reinvested at higher interest rate. Hence short investors prefer Futures when asset values are negatively correlated with short rates.
positive correlation would lead to futures prices being higher than forward prices. the future would be preferred because of the Mark-to-Market. when prices go up because rates go up - they receive higher prices (profits) due to mark to market - invest them at the higher prices. Even when price drops - the value obtained can be reinvested at the higher price. When rates are negatively correlated - forwards prices are preferred. So C is my choice as well.
This is Schweser Concept Checker question on “Futures” Chapter. Their answer is B, but I was not convinced, hence I posted here.
Think of it like this: You put up margin to buy gold contracts. If gold (an asset) starts going up, and interest rates go up too (because they are positively correlated), you are making money on gold, which is good. In addition, since you are making money on gold, your account gets credited with the gain on a daily basis (marking to market), so the margin you put up is released, so you are getting more and more cash each day, which you can invest in short term T-bills (not bonds), whose interest rate is going higher.
my bad… read it wrongly. while we got the concept right, we both did not read the answer choices correctly. they say forward prices will be lower than futures prices when… that would be B… postive correlation - higher futures prices…
Got it… thank you everyone!
Great, now that we all got that, please explain why wouldn’t a forward contract be even better in this case (of assets and interest rates rising), since with a forward contract you don’t pay anything upfront, which means you can deposit all of your funds in a short-term interest and earn more than you would using a futures?
margin earns interest too, it is not interest-free payment. as an example see: http://www.cmegroup.com/clearing/financial-and-collateral-management/collateral-types-accepted.html and in case of futures here in the example (asset values are positively correlated with short rates), you earn higher interest on MTM profits than interest “paid” on MTM losses, therefore the future price would be higher than forward price (convexity adjustment)
when the asset price is negatively correlated with interest rates (eg treasuries) I prefer forwards to futures and forward prices will be higher. When asset prices are positively correlated with interest rates, I prefer futures and futures prices are higher. Therefore, for forward prices to be lower, asset prices should be positively correlated with interest rates (B). Is that logic right?