Explanation

Forward and futures prices differ primarily due to the marking-to-market feature of futures contracts. The key difference arises from the correlation between futures prices and interest rates.

Key Concepts:

1. Forward contracts are settled only at expiration (no daily settlements)
2. Futures contracts are marked-to-market daily (daily settlements)
3. Daily settlements create cash flows that can be reinvested or require financing

Why Correlation Matters:

• When futures prices and interest rates are positively correlated:

  • Rising futures prices → Long position receives cash → Can invest at higher interest rates
  • Falling futures prices → Long position pays cash → Can borrow at lower interest rates
  • This creates an advantage for futures over forwards → Futures price > Forward price

• When futures prices and interest rates are negatively correlated:

  • Rising futures prices → Long position receives cash → Must invest at lower interest rates
  • Falling futures prices → Long position pays cash → Must borrow at higher interest rates
  • This creates a disadvantage for futures → Futures price < Forward price

• When futures prices and interest rates are uncorrelated:

  • No systematic advantage or disadvantage from daily settlements
  • Expected value of reinvestment/financing effects is zero
  • Forward price = Futures price

Mathematical Basis:

The relationship can be expressed as: Futures Price = Forward Price × e^(covariance term)

Where the covariance term depends on the correlation between futures price changes and interest rate changes. When correlation = 0, the covariance term = 0, making futures price = forward price.

Practical Implications:

• For most assets, the correlation is small enough that forward and futures prices are approximately equal
• For interest rate futures, the correlation is significant and must be considered
• The difference is more pronounced for longer-dated contracts

Therefore, forward and futures prices are equal when futures prices and interest rates are uncorrelated, making option B correct.