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For all financial instruments, it is important to be able to determine whether the price available in the market is an appropriate one. Hence, we engage in the process of “pricing” the financial instrument. A major objective of this post is to determine the appropriate price of a futures contract. Given the similarity between futures and forward prices, however, we can benefit from studying forward contract pricing, which was covered in former posts. But first, we must look at the similarities and differences between forward and futures contracts. Recall that futures contracts settle daily and are essentially free of default risk. Forward contracts settle only at expiration and are subject to default risk. Yet both types of contracts allow the party to purchase or sell the underlying asset at a price agreed on in advance. It seems intuitive that futures prices and forward prices would be relatively close to each other. The issues involved in demonstrating the relationship between futures and forward prices are relatively technical and beyond the scope of this post. We can, however, take a brief and fairly nontechnical look at the question. First let us ignore the credit risk issue. We shall assume that the forward contract participants are prime credit risks. We focus only on the technical distinction caused by the daily marking to market.
The day before expiration, both the futures contract and the forward contract have one day to go. At expiration, they will both settle. These contracts are therefore the same. At any other time prior to expiration, futures and forward prices can be the same or different. If interest rates are constant or at least known, any effect of the addition or subtraction of funds from the marking-to-market process can be shown to be neutral. If interest rates are positively correlated with futures prices, traders with long positions will prefer futures over forwards, because they will generate gains when interest rates are going up, and traders can invest those gains for higher returns. Also, traders will incur losses when interest rates are going down and can borrow to cover those losses at lower rates. Because traders holding long positions prefer the marking to market of futures over forwards when futures prices are positively correlated with interest rates, futures will carry higher prices than forwards. Conversely, when futures prices are negatively correlated with interest rates, traders will prefer not to mark to market, so forward contracts will carry higher prices.
Because interest rates and fixed-income security prices move in opposite directions, interest rate futures are good examples of cases in which forward and futures prices should be inversely related. Alternatively, when inflation is high, interest rates are high and investors oftentimes put their money in such assets as gold. Thus, gold futures prices and interest rates would tend to be positively correlated. It would be difficult to identify a situation in which futures prices are not correlated with interest rates. Zero correlation is rare in the financial world, but we can say that when the correlation is low or close to zero, the difference between forward and futures prices would be very small.
At this introductory level of treatment, we shall make the simplifying assumption that futures prices and forward prices are the same. We do so by ignoring the effects of marking a futures contract to market. In practice, some significant issues arise related to the marking-to-market process, but they detract from our ability to understand the important concepts in pricing and trading futures and forwards.