Higher reinvestment rates for gains and lower borrowing costs to fund those losses lead to a preference for the mark-to-market feature of futures, and higher prices for futures than forwards, when interest rates and asset values are positively correlated.
A preference to avoid the mark-to-market cash flows will lead to a higher price for the forward relative to the future if interest rates and asset values are negatively correlated.
Question: can someone explain to me how a positive correlation of interest rates and asset values result in higher futures price and lower forward price and vice versa?
If interest rates are higher, it costs more to borrow to fund losses, and should result in more demand for forwards. This seems to contrdict what it says about how low borrowing costs result in strong demand for futures.
If anyone can explain this relationship in Layman’s terms, that would be great.
Just finished that reading and that last section is a little confusing, however this is what I think is the key part from it:
+ve correlation -> preference for futures, because its settled/marked to market daily and you can get your cash and reinvest it at higher rates or if you lost, what you borrowed to enter the contract was at a lower rate than today so its also good. I believe its the opposite for negative correlation.
Basically, reinvestment risk is what they seem to be getting at.
If rates are positively correlated with future prices (i.e. rates go up and prices go up), the gains on mark-to-market can be reinvested at higher rates, and losses can be funded through borrowing at lower rates, so there is a preference for futures over forwards (and therefore a higher price for futures) when rates are positively correlated to future prices.
Key point here is that futures are cash collateralized, so when there are “gains” or “losses”, cash actually moves around in-line with those mark-to-market gains and losses.