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Answer: The price of the underlying asset is strongly negatively correlated with interest rates.
**Explanation:** C is correct. When an asset is strongly negatively correlated with interest rates, futures prices will tend to be slightly lower than forward prices. When the underlying asset increases in price, the immediate gain arising from the daily futures settlement will tend to be invested at a lower than average rate of interest due to the negative correlation. In this case, futures would sell for slightly less than forward contracts, which are not affected by interest rate movements in the same manner since forward contracts do not have a daily settlement feature. A is incorrect. Forward contracts are less liquid than futures contracts. Closing out is not as easy as it is for futures contracts. B is incorrect. Because futures contracts are traded on an exchange, they are standardized financial products. Forward contracts are traded over the counter, and their terms can be chosen to meet the needs of the counterparties. D is incorrect. Neither type of contract has upfront transaction costs.
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A risk manager is deciding between buying a futures contract on an exchange and entering into a forward contract directly with a counterparty on the same underlying asset. Both contracts would have the same maturity and delivery specifications. The manager finds that the futures price is lower than the forward price. Assuming no arbitrage opportunity exists, and interest rates are expected to increase, what single factor acting alone would be a realistic explanation for this price difference?
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 forward contract.
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