Journal of Banking and Finance 5 (1981) 483-496.

North-Holland Publishing Company

FORWARD AND FUTURES PRICING OF TREASURY BILLS

George Emir MORGAN*
Unirersity of Texas, Austin, IX 78712, USA Received March 1979, final version received March 1981 The paper discusses the recent literature on interest rate futures contracts applying both traditional futures and term structure theories. It is argued that an important characteristic of futures contracts has been ignored in most of the futures literature. By constructing a riskless arbitrage between implicit forward contracts and futures contracts, it is demonstrated that even in an efficient market the futures and forward prices will be different. The difference results because the 'marking to the market' that is required on a futures contract implies that the course of interest rates is important to the pricing of interest rate futures contracts.

1. Introduction

Interest rate futures have been touted as futures contracts in the ultimate commodity, money, and indeed the rapid rise in volume and open interest have made interest rate futures contracts one of the success stories of the 70's (along with the success of options contracts). Paralleling the explosion of volume of trading in T-bill futures contracts,' there has been a substantial increase in the number of papers and articles devoted to empirical investigation of interest rate futures prices. See Poole (1978), Lang and Rasche (1978), Puglisi (1978), Vignola and Dale (1979), Chow and Brophy (1978). Ederington (1979), and Rendleman and Carabini (1979). Poole (1978) provides convincing evidence that no arbitrage opportunities exist. in the near futures contract once transaction costs are included. Lang and Rasche (1978) have examined behavior of distant contracts as well as the near contract and found substantive dilTerences between prices implied by the cash market and futures prices. Puglisi (1978) asserts that such dilTerences present opportunities for profits by hedgers. Rendleman and Carabini (1979) have found that there is no consistent divergence between T-bills and futures prices. but they do find an unusual number of circumstances where
*My appreciation is due Bob Kolb, Dick Rendleman, and Richard McEnally for their valuable comments on earlier drafts of this paper and to an anonymous referee who significantly enhanced the clarity of the presentation in the third section. I In this paper only 91 day T-bill futures will be discussed explicitly, but many of the points made apply to any interest rate futures contracts. Arthur (1971) is an excellent description of futures markets in general and Bacon and Williams (1976), Hamburger and Platt (1975), or Puglisi (1978) can be consulted for background material on T-bill futures.

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©

1981 North-Holland

some writers have considered futures contracts as a type of forward contract.f It will be shown in the next section that futures contracts can be 2For example. This assumption is not consistent with daily resettlement. The course of interest rates is irrelevant to forward contract pricing but is important to buyers and sellers who must agree on a futures contract price. In fact. he reverts back to the standard formulation when he assumes that the forward 'price is always equal to the current futures price' when the forward contract is initiated. Fischer Black (1976) has come closest to a careful analysis of the underlying qualities of futures and forward contracts. Unfortunately after Black recognizes this difference between forward and futures. The third section demonstrates that the expected course of interest rates is as important to the pricing of futures contracts as the expected future price of T-bills on the delivery date. Forward and futures pricing of treasury bills divergences occur. The fourth section is a short digression on the need for futures contracts followed by sections analyzing the theoretical price discrepancy and the effects of relaxing some assumptions.E. The last section is a summary. The differences in prices result from the effects of the anticipated course of interest rates over the time to expiration. futures contracts. . Black carefully points out that futures contracts have no 'value' at the end of the trading day whereas forward contracts may have 'value'. for example. and daily marking to the market. Throughout the paper. and therefore. an attempt is made to synthesize the traditional futures literature and the literature on the term structure of interest rates. The paper presents a means of describing the way in which differences will arise and cannot be arbitraged away. It is the purpose of this paper to show that observed discrepancies between forward and futures prices are not necessarily the result of inefficiencies but rather should be expected to occur in an efficient futures market. There is even confusion over what instrument should be used to hedge an interest rate futures contract. It wi11 be shown in what follows that Black (1976) and others have not adequately incorporated the effects of the daily resettlement process where profits are denominated in terms of changes in price. The paper continues 'with a section that describes forward contracts. The nature of futures contracts Some background discussion in futures and forward contracts is necessary for a full 'understanding of futures contracts because the two are very similar.484 G. Sharpe (1978). Morgan. Ederington (1979). 2. futures prices cannot equal forward prices even when the forward contract is initiated and evell ill all efficient market. The difference results from the daily resettlement process that the exchanges require of both sides to a futures contract.

Therefore. this section will provide a definition of forward and futures contracts and describe the nature of futures contracts as they are currently traded on the Chicago exchanges. They suggest that their viewpoint is consistent with the fact that nearly all forward contracts are held to delivery date while only a small percentage of futures contracts result in delivery of the commodity. Futures contracts are only traded on standardized commodities. Often 'futures contract' is defined in this manner. thus." A forward contract is a contract whereby the seller agrees to deliver a commodity to the buyer at a specified date and price. Morgan. 6It is clear that risk is not entirely eliminated since there may be no trading at all due to price limits. With a futures contract. The combination of required resettlement and price limits accomplishes the goal of eliminating a large part of the exposure of the clearinghouse and the brokers. There is no initial cash flow between the two parties at the time of agreement. Profits are credited to the investor's account or losses are withdrawn. 4The Chicago Board of Trade and The Chicago Mercantile Exchange. The question of the need for both kinds of contracts is deferred to a later section. the price at which delivery will actually occur is not fixed. sThe definition is consistent with Black (1976) and Telser and Higinbotham (1977). the mechanics of marking to the market are that the profit or loss reflected in the change in price during the day's trading must be settled at the end of the day.' Prior to discussing pricing. Telser and Higinbotham (1977) have noted that the commodities exchanges perform an insurance function and thus broaden participation in contracts relating to future delivery of a commodity.E. and the broker may take a loss on the position that is not covered by the maintenance margin. Forward and futures pricing of treasury bills 485 constructed from forward contracts. Instead. Brokers may not be able to liquidate the positions of customers in default. and the price cannot change between date of agreement and delivery date. In general. the possibility of default by either party to a forward contract is a major deterrent to forward contracting. and the specific characteristics of a deliverable commodity are established by the exchanges. can be used to 'lock-in' the price for a transaction in the future and avoid the risk of price fluctuations. See Arthur (1971) or Hoel (1976) for a more detailed discussion. Telser and Higinbotham recognize that an integral part of the insurance function is the imposition of limits on daily price movements and a daily 'marking to the market' of all open contracts. the price changes from day to day with recontracting occurring. Essentially. futures trading (which only occurs on organized exchanges) has been backed by clearinghouses of each of the exchanges that guarantee performance on contracts and match buyers and sellers at the delivery date.G." Forward contracts." Those two features of futures contracts are the major differences 3Sharpe (1978) makes a similar argument. . The purpose of this institutional structure is the next topic considered.

. It can be shown that the forward contract implicit in the term structure is priced the same as if it were a default free explicit forward contract.has not been properly accounted for in any empirical research to date. however. More will be said in a later section regarding the default risk hypothesis. Initial margin is usually required as a performance bond. The traditional assumptions of no market frictions or transaction costs. Morgan. While it is agreed that futures and forward contracts are different though related instruments. the cash used to purchase a spot contract must be used to purchase a T-bill when buying a futures contract. 9Ederington (1979) uses the 91 day T-bill as the hedging vehicle against the futures contract when the correct vehicle must have a maturity greater than 91 days (or alternatively. but a hedger can used the hedged T-bill as initial margin.486 G. See Burger. The discrepancies get larger as the distance of the delivery date gets farther away.'? perfectly divisible securities. Risk neutrality is the most convenient. Implications of risk aversion are included in the section on relaxation of assumptions. Consider the choices facing an arbitrageur on the day before the futures contract's delivery date: 7Currency forward and futures markets have existed side by side. the maturities have been so seldomly synchronized that observations on price differentials are difficult to obtain. homogeneous beliefs. round trip commissions on a $1 million T-bill futures contract is $60. he concluded that the parameters of the model are 'close' to being equal. Forward and futures pricing of treasury bills between forward contracts and futures contracts and may be the source of any differences in prices. it is argued here that a major aspect of futures contracts . 11 It is well known that in valuing a riskless arbitrage in complete markets that any utility function can be employed. Lang and Rasche (1977) or Bacon and Williams (1976) for a more detailed discussion of the arbitrage. 3.the daily resettlement based on price changes . symmetric distributions." Lange and Rasche (1978) recently provided evidence that a pattern of discrepancies between forward and futures prices has persisted since the initial trading of T-bill futures contracts. should be the forward contract implicit in the term structure). Lang and Rasche (1978) have argued that a differential default risk is a possible source of differential pricing. lOTransactions costs on futures contracts are very small relative to the face value. but unfortunately. The effects of relaxing some of these assumptions is addressed in a later section. 8Most often the arbitrage is described in terms of shorting one maturity T-bill while buying a longer maturity to create an implicit forward contract. To make the arbitrage opportunities equivalent. and risk neutrality!! are adopted here. Early explanations of such differences concentrated on market inefficiencies and the inexperience of market participants in the new interest rate futures market. Thus initial margin is irrelevant to equilibrium pricing. For example. T-bill futures prices relative to forward prices The traditional arbitrage" of one 91 day T-bill futures contract versus a spot T-bill9 can be used to determine the equilibrium price of a futures contract.E. Denis (1976) did find some significant differences in prices.

it can be generally true only when the number of days to delivery is 1 or o. 1 1 1 (1) where superscripts denote the date (in terms of number of days before delivery) at which the price prevails.'buy' the futures contract to a 91 day T-biII thus 2 . If there is more than one day to the delivery date. buy a 92 day T-bill or. subscripts are number of days to maturity. Forward and futures pricing of treasury biIls 487 (a). and 'fut' denotes a futures contract for delivery of a 91 day T-biII to be delivered on day O. Eq. Because the daily settlement process creates realized daily 'profits' or 'losses'. then the choices an arbitrageur has are basically the same but with the added obligation in a futures contract to 'mark to the market'. The no-arbitrage condition now requires that the present value (as determined by the D day T-biII rate) of (a) equal the present value of (b)1 plus (b)2. In equilibrium in an (otherwise) perfect market 1 1 D D P D + 9 1=1+ DPrul+l+ rD D-I " D . but as wiII be shown below. The present values are determined by the 1 day spot T-biII rate. (1) implies that on the day prior to delivery (2) This is the commonly recognized relationship between futures and forward prices. or (b) 1 . The cost of (a) is already in present dollars and must equal the present value of (b) if no arbitrage opportunities are to prevail. the present value of the benefits of those cash flows over the life of the contract may be positive or negative. (b) 'buy' the futures contract to a 91 day T-bill.G. Morgan.obligating oneself to abide by the exchange's clearinghouse process of daily resettlement of futures contracts. The choices are (a) buy a D+91 day T-biIl. The second term on the right-hand side of (3) is the interest expense or revenue that results from the daily resettlement of the futures .E. Thus in equilibrium: P 92 = 1 + r~ P rut.I D-I rul )rD-p D LJ r D 1=1 (LiP (3) where L1 is the backward difference operator and r~ is the D day interest rate defined by the spot price P~ which is observed D days prior to delivery as defined earlier. say D days.

there is an interest expense of borrowing the cash until the delivery date when the loss is recouped. The change in value of the two alternatives must be equal if the no-arbitrage condition holds. The cash flows from rebalancing would go to finance the daily resettlement on the futures contract with any excess or deficiency loaned or borrowed until delivery date with a net profit accumulated at that time. the course of rates over time is important to the pricing of futures contracts. [Note that the prices P?u. Eq.( ApD-I) rD-I PD lor= lut+ L. (4) also implies that autocorrelation will be observed in the time series of differences.] If marking to the market results in the necessity to send cash to the clearinghouse. Eq. LJ Iut D. (4) shows that the difference between the futures price and the forward price is related to the expected changes in forward rates between agreement and delivery and related to the expected discounting rates over the time period. Morgan.488 G.] If eq. That is.t. The interest expense or revenue is realized at the delivery date and therefore the D day rate is employed as the discount rate in (3) similar to (1). riskless arbitrage could be undertaken. Thus' the presumption by most researchers that futures and forward prices should be equal in an efficient market is incorrect. a cash inflow generates the reinvestment income of interest revenues.-I is derived below in (6).dp?u. [The relationship between and . (3) can be rewritten as D-l 1= 1 pD . where only the forward price changes. but substitution of (6) in (3) and (4) only results in making the second terms in (3) and (4) appear as functions of changes in forward prices rather than futures prices. These additional flows may be called the 'cost of carrying' the arbitrage. (4) did not hold true. Consider the change in the value of alternatives (a) and (b) from D+ 1 to D. The futures prices in the second term of (3) all refer to the same futures contract observed at the various times D . Eq. Therefore the present value of the change in the futures price plus the change in the present value of the interest expense or revenue must equal the change in the price of a T-bill that rg=: .t. futures and forward prices will not be equal. Futures prices must be different from forward prices as long as it is believed that there is some chance that futures prices will change through time.-I are not prices on futures contracts with delivery at D . On the other hand. (3) may be more enlightening in its dynamic form.1 (4 ) from which it can be seen that as long as futures prices are expected to change. Forward and futures pricing of treasury bills contract.. Thus it is not surprising and is supportive of the analysis here that Vignola and Dale (1979) have found autocorrelation (putting aside their annualizing factor which itself induces autocorrelation) as Rendleman and Carabini (1979) also have found. Eq.E.

Forward and futures pricing of treasury bills 489 will be deliverable on the futures contract. 1 +rD +rD +rD 1 DID 1 DD (5) or (6) Notice that the change in value of alternative (a) is exactly the amount required for marking to the market. but because that is true. Morgan. Are futures contract needed? Given the analysis developed in the previous section and the traditional analysis. See Rendleman and Bartter (1979) for an example from the options literature. i. the daily resettlement poses no hardship and in fact is a crucial part of the daily rebalancing of the hedge. mutual funds. 4. -1 D AP ro r = .P Nonetheless.G. So the futures-forward differential is related to resettlement under the current institutional arrangement. resettlement based on denomination of profit and loss in terms of discounted forward prices would remove any futures-forward price differential. the need for the existence of futures contracts can be questioned. .1 D AP rut +D rDAP rut. futures and forward prices must differ by virtue of the daily resettlement. government securities dealers) can perform quasi-arbitrage and are more likely to incur 12The hedging and arbitrage discussed here is the discrete time analog of the continuously rebalanced Black-Scholes (1973) riskless hedge.e. futures and forward prices cannot be equal. then what does a futures market offer to an economy? First it must be realized that the arbitrage strategy outlined above may not be available to all investors.E. Otherwise the two alternatives would not have equivalent changes in value. then. (6) that a futures contract can be created with continual rebalancing of an implicit forward contract to create cash flows exactly equal to the flows from daily resettlement on a futures contract.. however. If futures contracts can be constructed by rebalancing forward contracts. The forward price and changes in the forward price relate to a future event (the delivery) and thus must be discounted while the daily resettlement and the change in the futures price occurs in the present. Large investors (banks. corporations. When the alternatives are viewed as an implicit forward contract versus a futures contract it can be seen with eq. The insurance function of the clearinghouse has dictated the process of resettlement which is based on the denomination of profits in terms of the change in price. In discrete time models recursive or enumerative methods are commonly used. For a hedger.

all the terms in the summation on the right-hand side of (4) are zero. Part of the lower transaction costs relate to the lower perceived (perhaps because of better information that is more easily obtainable) risk of default in dealing with such institutions. as discussed above. however. 5. Malkiel (1966). The clearinghouse. Thus there will be enough market participants to assure that equilibrium prices will prevail. These restrictions and frictions in T-bill cash markets . and Stevenson and Bear (1970). The theory implies that the expected change in the forward price is zero. The existence of futures contracts offers more economic units the . Stein argues that given a utility function and beliefs about return distributions there is an optimal proportion of a portfolio that should be hedged. Tewel es. The next section examines and analyzes the character of the price differential implied by the theoretical relationship shown in eq. Morgan. This is a substantial problem in the commodity cash markets and is a problem of only slightly lesser magnitude in the T-bill market.490 G. Harlow and Stone (1969). On term structure th eorie s. See Fama (1976). The existence of forward-like contracts for which there are fewer restrictions (either economic or institutional) facilitates the attainment of the optimal portfolio allocation among risky investment opportunities in a world where there are short restrictions and forward contracts are bundled with spot contracts. (6).a nd the explicit forward market are important from the viewpoint provided by Stein (1961). see Hamburger and Platt (1975). Factors which prevent investors from achieving the optimal hedged position (which will only be 100 percent or zero percent in unusual circumstances) result in investors holding a portfolio that is suboptimal in terms of risk of investment. This is particularly important for taking a short forward or futures position since there are restrictions (related to default potential in some senses) on shorting in the cash market where forward contracts are 'bundled' with spot contracts. Under the unbiased expectations 13There is a parallel theory for 'futures' (fonvard) pricing that asserts th at price s are unbiased forecasts of future spot price s. provides insurance to investors so that there is no need to acquire information about the other side of the contract. not all investors can transact with low costs and good information. Because there is no expected change in future forward rates.E. Wood (1964).'? forward prices are expectations of future prices of T-bills. opportunity to hedge cash positions than would be the case with either explicit or implicit forward contracts. Forward and futures pricing of treasury bills low transaction costs in shorting T-bills. . Analysis of the price differential Under the unbiased expectations theory of the term structure of interest rates. and the difference between the forward price and the futures price is zero.

E. the expected change in the forward price is positive. The evidence provided by Lang and Rasche (1978) indicates rejection of the null hypothesis of unbiased expectations since significant. (4). That implies that tests of the equality of the implicit forward rate and the futures rate are tests of the expectations hypothesis. and because using Roll's (1970) estimates of liquidity premia.!" From eq. Fomard and futures pricing of treasury bills 491 hypothesis. The default risk explanation cannot fit comfortably with both positive and negative differentials in different contracts at the same point in time whereas the analysis presented here suggests that different portions of the timepaths of interest rates were relevant. The theory developed here provides some explanations for this observed phenomenon that appear more plausible than other explanations advanced. The Lang and Rasche empirical analysis does not appear to verify the liquidity premium theory in any but the nearest-todelivery contracts since futures prices have been observed consistently below forward prices." In other words. Rates did not rise that quickly. the greater the difference between forwards and futures. in fact. "See Malkiel (1966). their observations are consistent with an expectation that forward prices would fall over the time period or that rates would rise over the relevant time periods. rates could be expected to fall while over longer periods rates could be expected to rise. Assuming investors are rational though not infallible. The Lang and Rasche (1978) and Puglisi (1978) analyses indicate that futures prices have been consistently lower than forward prices in most contracts. Roll (1970) or Modigliani and Schiller (1973). then. there is a theory of forward interest rates that suggests that forward rates incorporate not only expectations but also a liquidity premium to compensate investors for potential losses incurred in the event that the securities are liquidated prior to maturity. (4). consistent differences are observable. 1 am indebted to Professor Henry Latane for bringing this latter point to my attention and for suggesting that a more general theory of the term structure would include both risk factors working against one another in determining forward interest rates. On the other hand. 14More is said on the issue of risk premia at the end of this section. 161n the 'futures' (forward) pricing literature this is called normal backwardation. the liquidity premium theory produces futures prices that are higher than forward prices and the more distant the delivery date. The two theories differ in the assumption of who the hedgers in the market are. the Lang and Rasche difference of 60 basis points would correspond to expectations that rates would rise at a rate of 100 basis points a month. the evidence is consistent with the theory developed here. but.!" That is. Lang and Rasche (1978) found some cases where futures prices have been significantly higher than forward prices particularly in contracts nearer to delivery. Nelson (1972). The contango theory asserts that forward prices should be higher than expected prices and thus prices are expected to fall over time. From eq. A theory of bond pricing analagous to the contango theory would be a theory that concentrates on 'income risk' instead of 'liquidity risk'. did rise over the periods considered. . At organ.G. As an approximation. forward and futures prices will be the same. over a short period.

6. Unfortunately. there is no method known to measure expectations regarding the time path of the liquidity premium. The existence of a differential between rates at which gains can be reinvested and losses can be borrowed should magnify the size of the effects discussed here.. The effect of relaxing some assumptions The qualitative effects of relaxing four assumptions can be examined to provide insight into more realistic futures pricing. In the traditional literature the controversy over the existence of premia centers on different assumptions regarding who the hedgers are. Furthermore. In addition. . The existence of a premium cannot be justified based on traditional arguments. there are few restrictions on active market participants 19 creating 17This may occur in consonance with a cyclical rise in risk premia as examined in Fisher (1959). Friedman (1979) also provides evidence that the size of the liquidity premia may be related to the level of interest rates. on net. lower than the future price. as is the case in the T-biII markets."? the forward price might be. these distinctions are not meaningful. If it were believed that the liquidity premium would increase to a peak and then drop during the period between agreement and delivery date. In some markets. the issue of risk prernia'" in the futures market that are not already contained in the forward market is important for pricing.E. 18Dusak (1973) recently pointed out that conceptually only systematic risk is relevant to the existence of a risk premium. Forward and futures pricing of treasury bills the magnitude of the effects would be on the order of 5 basis points which is much smaller than the observed effects.easily arbitrage the futures markets either way. Morgan. For example. segmentation or preferred habitat theories may be consistent with the data since no smooth or monotone pattern of premia are presumed in those theories. The skewness of the distribution of price changes becomes important when there is also a borrowing-lending rate differential and wiII increase the magnification of other effects such as the movement of liquidity premia over time.e. An asymmetric distribution of price changes is more appealing than symmetric distributions because of the lower bound on price changes (i.100 percent) and because empirically a lognormal distribution appears to fit the data better than a normal distribution. Are the hedgers short hedgers or long hedgers? In the first case. however. Upon relaxing the assumption of risk neutrality. . speculators must be paid a risk premium to take long futures positions. or as the result of increased uncertainty regarding the direction of monetary policy in a rapidly changing economic environment. the effect of expected shifts in the liquidity premium structure itself could create larger differential prices. can . In the second case. 19In both these markets. banks and large corporations. speculators must be compensated for short positions that allow the hedger to get the desired insurance. Burns (1976) points out that whether a premium or discount exists in foreign exchange futures depends on 'which side of the coin' is considered.492 G.

The differences between the traditional literature and the arguments made here are the result of the different instruments given consideration. they suggest that default risk may account for some of the differential. then it may be possible for the investor to exact risk compensation because the current equilibrium price from (4) is unknown. A risk premium of another sort may be justified if the assumption of homogeneous beliefs is relaxed. .i? That is. the clearinghouse guarantees both sides of the contract. Furthermore. The default to which they refer is the default of an investor. Furthermore. Morgan. two different agreements are considered: one to buy a commodity at a future date and one to buy a commodity immediately. The price in each case is different and there is reason to believe that hedgers of the spot commodity would pay an insurance premium that would systematically bias forward prices. and the exchange membership on either resettlement or delivery. Although this risk could be considered entirely non-diversifiable.E. there appears to be little support for the contention that T-bill futures contracts are systematically biased by an insurance premium paid by hedgers of forward contracts. But even that risk premium has some implausibility since there are two parties subject to that same risk on every contract. riskless arbitrage [or what Rendleman and Carabini (1978) call quasiarbitrage] is a more accurate description of the process. If an investor is unaware what other investors believe about the course of interest rates. any observed price discrepancies can be captured by entering into a riskless arbitrage. his broker. Traditionally. if in developing eq. Forward and futures pricing of treasury bills 493 short hedges or long hedges. the exchange clearinghouse. the event is so remote that the resulting premium could not be large enough to explain observable differences. no change in the ensuing equations would be required and the futuresforward differential would still be given by (4) in terms of expected changes in forward rates. and as discussed earlier. it is unclear why the short side of the contract should receive a premium on near contracts. (3) a risk adjusted discount rate were used to discount to the present net cash flows received at delivery date. interest rate risk/horizon risk is many orders of magnitude larger than this default risk. In contrast. For example. The activity of market participants to capture premia while taking a riskless position will result in the premia being bid away. Although Lang and Rasche (1978) note the implausibility of a risk premium in futures markets when riskless arbitrage possibilities exist. Similarly. 2°In some cases. it is not entirely clear how the default premium explanation used by Lang and Rasche (1978) necessarily implies a premium for the long side of the contract for distant contracts since the long side may also default. yet it is generally believed that 50 to 100 basis points is the magnitude of the liquidity premium.G.

an 'independent' source of interest rate expectations is needed (and in the case of T-bill futures.. For example. Morgan. Chow and Brophy (1978). there will be a difference between forward and futures prices because futures prices incorporate expectations regarding the course of interest rates between agreement and delivery dates whereas forward prices do not. .ard and futures pricing of treasury bills 7. 22Rendleman and Carabini (1979) could be used as evidence to support the acceptance of the expectations hypothesis. Unfortunately. many brokerage houses tout the profit opportunities by referring to the standard formula that presumes forward and futures are the same. A major difference. that results from the insurance role of the clearinghouse of a futures exchange. Even in an efficient market. In order to test the theories. It was demonstrated that this difference would result in different prices for forward and futures contracts.494 G. Poole (1978). direct. it appears that term structure efforts are back at the starting point.21 By their construction. even in an efficient market. T-bill futures prices are not such a source in either case. For.. . Puglisi (1978) advises that the observed discrepancies are profit opportunities waiting to be exploited by simple riskless hedges or arbitrage strategies. The evidence.. Thus their analysis of the empirical evidence must be suspect. The analysis suggests that empirical tests can provide evidence regarding the validity of some of the theories of the term structure because some of those theories imply hypotheses regarding the course of interest rates. market forecasts of future interest rates at a single future time point. That is. seems to favor rejection of the expectations hypothesis. and Puglisi (1978). 21This has no implication for Poole's empirical work since he only considered the contract nearest to delivery where the effects analyzed here have little impact. so far. futures prices also include data regarding market expectations of the future course of interest rates over a time period. expectations about movements in forward rates). is the requirement of daily marking to the market. the analysis presented here dashes any hopes of testing term structure hypotheses a la Chow and Brophy (1978) or more generally of using futures prices as easily accessible. Poole (1978).. Similarly. Summary and conclusions A discussion of the nature and usefulness of futures contracts revealed that there are a number of differences between futures and forward contracts. Empirical studies have all presumed that in efficient markets forward and futures were the same.E. contrary to the presumptions made by Lang and Rasche (1978). it appears that it will be difficult to test the appropriateness of other term structure theories versus the liquidity premium theory since so little has been done on the movement of liquidity premia over time.F On the other hand. This is particularly troublesome given that the analysis here indicates that the 'discrepancies' call result from efficient pricing based on expectations that rates will rise over the relevant time period.

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