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Answer: The price of the underlying asset is strongly negatively correlated with interest rates.
The correct answer is C. When an asset is strongly negatively correlated with interest rates, futures prices will tend to be slightly lower than forward prices. This is because when the underlying asset increases in price, the immediate gain from the daily futures settlement will be invested at a lower than average rate of interest due to the negative correlation. As a result, futures would sell for slightly less than forward contracts, which do not have a daily settlement feature and are not affected by interest rate movements in the same manner.
Author: LeetQuiz Editorial Team
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A financial risk manager is evaluating two investment options involving the same underlying asset: purchasing a futures contract through an exchange or entering into a forward contract with a counterparty. Both contracts share identical terms regarding maturity dates and delivery conditions. Notably, the futures contract is priced lower than the equivalent forward contract. Considering there are no arbitrage opportunities and interest rates are expected to increase, what is the single factor that could logically explain the observed price difference between the futures and forward contracts?
A
The futures contract is less liquid than the forward contract.
B
A futures contract offers more flexible terms than a forward contract.
C
The price of the underlying asset is strongly negatively correlated with interest rates.
D
The upfront transaction cost on the futures contract is higher than that on the forwardcontract.
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