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FRM Part I · FRM Exam Part I · Interest Rate Futures

Which statement about the relationship between Eurodollar futures rates and forward rates is correct?

The forward rate is lower than the futures rate, and the convexity adjustment increases with rate volatility and time to maturity. Daily settlement of futures creates a mismatch in margin gains and losses that forwards do not have, so longer-dated contracts need larger adjustments.

  1. AThe forward rate is lower than the futures rate, and the adjustment grows with both volatility and time to maturity.Correct
  2. BThe forward rate is higher than the futures rate, because daily settlement favors the short position.
  3. CThe adjustment is the same for all maturities, because each contract has the same $25 per basis point value.
  4. DNo adjustment is needed, because both futures and forwards are marked to market daily.

Explanation

Daily settlement means a long futures position gains margin when prices rise, which happens when rates fall, and loses when rates rise. The margin effects are therefore asymmetric, so the futures rate exceeds the forward rate. The adjustment, 0.5σ²t₁t₂, rises with volatility and maturity. Forwards are not marked to market daily, so the last option is wrong.

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