I always get a little bit confused about the following question. Given future/forward are doing similar thing, I assume whether future/forward price is higher, depends on whether or not future is "better" than forward (otherwise people can choose the other instrument while achieving the same goal).
Based on this:
A. future is worse (since less liquid)
B. future is better (since less credit risk)
C. future is worse (as in the answer explanation, daily settlement is invested in lower rate)
D. future is worse (as it has higher transaction cost)
So at least the answer is not C based on my thought. Which part do I miss here? Thanks!
1. A risk manager is deciding between buying a futures contract on an exchange and buying a forward contract directly from a counterparty on the same underlying asset. Both contracts would have the same maturity and delivery specifications. The manager finds that the futures price is less than the forward price. Assuming no arbitrage opportunity exists, and interest rates are expected to increase, what single factor acting alone would be a realistic explanation for this price difference?
A. The futures contract is less liquid than the forward contract.
B. The forward contract counterparty is more likely to default.
C. The price of the underlying asset is strongly negatively correlated with interest rates.
D. The transaction cost on the futures contract is more than that on the forward contract.
Correct Answer: C
Explanation: When an asset is strongly negatively correlated with interest rates, futures prices will tend to be slightly lower than forward prices. When the underlying asset increases in price, the immediate gain arising from the daily futures settlement will tend to be invested at a lower than average rate of interest due to the negative correlation. In this case, futures would sell for slightly less than forward contracts, which are not affected by interest rate movements in the same manner since forward contracts do not have a daily settlement feature. The other three choices would all most likely result in the futures price being higher than the forward price.
Based on this:
A. future is worse (since less liquid)
B. future is better (since less credit risk)
C. future is worse (as in the answer explanation, daily settlement is invested in lower rate)
D. future is worse (as it has higher transaction cost)
So at least the answer is not C based on my thought. Which part do I miss here? Thanks!
1. A risk manager is deciding between buying a futures contract on an exchange and buying a forward contract directly from a counterparty on the same underlying asset. Both contracts would have the same maturity and delivery specifications. The manager finds that the futures price is less than the forward price. Assuming no arbitrage opportunity exists, and interest rates are expected to increase, what single factor acting alone would be a realistic explanation for this price difference?
A. The futures contract is less liquid than the forward contract.
B. The forward contract counterparty is more likely to default.
C. The price of the underlying asset is strongly negatively correlated with interest rates.
D. The transaction cost on the futures contract is more than that on the forward contract.
Correct Answer: C
Explanation: When an asset is strongly negatively correlated with interest rates, futures prices will tend to be slightly lower than forward prices. When the underlying asset increases in price, the immediate gain arising from the daily futures settlement will tend to be invested at a lower than average rate of interest due to the negative correlation. In this case, futures would sell for slightly less than forward contracts, which are not affected by interest rate movements in the same manner since forward contracts do not have a daily settlement feature. The other three choices would all most likely result in the futures price being higher than the forward price.
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