I think I’m missing something here. I read that 'when interest rates and futures prices for an asset are uncorrelated, it is most likely that the price of a forward contract is equal to the future…but if there is strong negative correlation, then the forward price will be greater than the futures price.
I think I may not be getting this. Does this have to do with daily settlemnt of futures? (It must right?) I guess what I don’t get is why would the price of a future go down if interest rates go up? Is it simply because people sell out of futures and put money to work right away with this new interest rate?
Thanks!
I has to do with daily marking to market and the fact that the margin account earns interest.
If there is a strong positive correlation of interest rates and futures prices, then when prices go up the long position has a larger margin account and it earns higher interest, while when prices go down the long position has a smaller margin account and it loses lower interest. Either way favors the long position, so the futures price is higher.
If there is a strong negative correlation of interest rates and futures prices, then when prices go up the long position has a larger margin account and it earns lower interest, while when prices go down the long position has a smaller margin account and it loses higher interest. Either way disadvantages the long position, so the futures price is lower.
Perfect, that’s exactly what I was missing. Many thanks.