Answer: Both interest rate volatility and the correlation between futures prices and interest rates

The differential between forward and futures prices arises due to the distinct cash flow patterns of these contracts. Under specific conditions—such as constant interest rates or uncorrelated futures prices and interest rates—forward and futures prices may align. However, deviations from these conditions can lead to pricing differences. For instance, if futures prices are positively correlated with interest rates, long futures positions become more advantageous than forward positions. This is because profits from rising futures prices can be reinvested during periods of increasing interest rates, while losses occur when interest rates decline. Additionally, the magnitude of the price differential is affected by the volatility of interest rates. Thus, both interest rate volatility and the correlation between futures prices and interest rates determine the differential between forward and futures prices.

Author: LeetQuiz Editorial Team