Question

Is the futures price of a fixed rate bond likely to be higher, lower or the same as its forward price? Explain pls

Answer 1

Consider a futures contract on a particular bond. If interest rates move down and then up, the price of the bond will increase, then decrease. The long position will make money in the first day, and invest it at a low interest rate. In contrast, the short position will loose money in the first day but be able to finance this loss at a lower rate. On the second day, the short wins and invests the proceeds at a high rate, while the long looses and has to finance the loss at a higher rate

Relative to a forward contract, the advantage rests with the short position. Of course, the long position realizes this and requires the futures price to be set a bit lower so as to compensate for this disadvantage. Clearly, the magnitude of this compensation, depends on the sensitivity of bond prices to the daily interest rate.

CONCLUSION

In summary, due to interest rate uncertainty, the setting of futures prices may differ from that of forward prices. Indeed, for a futures contract the total cash flow, together with accrued interest depends not only on the behavior of the future spot price but also on the joint behavior of the underlying price with interest rates.

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