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Subject 1. Why do Forward and Futures Prices Differ? PDF Download

In assigning a forward price, we set the price such that the value of the contract is zero at the start. During the life of the forward contract, the value will fluctuate as market conditions change. The original contract price, however, remains the same.

Unlike forward contract prices, however, futures prices fluctuate in an open and competitive market. The marking-to-market process results in each futures contract being terminated every day and reinitiated.

If we ignore the credit risk issue (futures contracts are essentially free of default risk as they are settled daily but forward contracts are subject to default risk), we should conclude that:

  • The price of a futures contract will equal the price of an otherwise equivalent forward contract if interest rates are known or constant. Under this condition, any effect of the addition or subtraction of funds from the marking-to-market process can be shown to be neutral.

  • The price of a futures contract will equal the price of an otherwise equivalent forward contract if interest rates are uncorrelated with future prices.

  • If interest rates are positively correlated with future prices, futures will carry higher prices than forwards.

    • Traders with long positions will prefer futures over forwards, because futures will generate gains when interest rates are going up (and thus future prices are going up as they are positively correlated), and traders can invest these gains for higher returns.

    • Traders will incur losses when interest rates are going down and can borrow to cover those losses at lower rates.

    • Gold futures are good examples in this case, as gold futures prices and interest rates would tend to be positively correlated.

  • If futures prices are negatively correlated with interest rates, traders will prefer not to mark to market, so forward contracts will carry higher prices. Interest rate futures are good examples in this case: interest rate and fixed-income security price move in opposite directions.

User Contributed Comments 3

User Comment
danlan2 Positively related to interest rates: gold futures; negatively related: fixed income futures.
bmeisner I'll tell you what, gold futures are definitely not positively correlated with interest rates these days. If interest rates are falling then the dollar is falling and usually gold is rallying in that case.
mcspaddj Gold typically follows the rate of inflation. As inflation rises, rates generally rise, leading us to believe gold is more strongly tied to rates rather than inflation. The current market is certainly reminding us of this phenomenom right now. Rates are falling, but inflation is rising, so gold is rising. If we were to run the regression after the current market mess is over, we should see the correlation between gold prices and interest rates decrease relative to the correlation before the Summer of 2007.
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Colin Sampaleanu

Colin Sampaleanu

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