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Answer: A forward rate agreement (FRA) based on a 3-month market reference rate
The correct answer is **B** because the convexity bias in forward rate agreements (FRAs) arises due to their discounting feature, which is absent in futures contracts. The bias increases with the length of the discounting period, which is determined by the maturity of the underlying market reference rate. A 3-month market reference rate results in a longer discounting period compared to a 1-month rate, leading to a larger convexity bias. Conversely, interest rate futures contracts (Option C) do not exhibit convexity bias because their pricing is linear and not based on discounting.
Author: LeetQuiz Editorial Team
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Which of the following interest rate derivatives is most likely to exhibit the greatest convexity bias?
A
A forward rate agreement (FRA) based on a 1-month market reference rate
B
A forward rate agreement (FRA) based on a 3-month market reference rate
C
An interest rate futures contract based on a 3-month market reference rate
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