Market Incompleteness and Divergences Between Forward and Futures Interest Rates*

Abstract

A PRESIDENTIAL ADDRESS IS a solemn ceremonial event. The words should perhaps be sung rather than recited. Not being in very good voice, I intend to give the shortest presidential address in AFA history. The presidential address is 1600 Pennsylvania Avenue, N.W. In the rest of the time allotted to me, I profess only to deliver a paper. My paper offers some new perspectives on the logical basis for expecting divergences between yields quoted for futures contracts and parallel forward yields implicit in the term structure of interest rates. The presentation proceeds by focusing on the equilibrium prices of alternative ways of making two-period investments and on assumptions that differentially affect the ways that spot, futures, and options markets for bonds can be completed. Implications are drawn regarding observable divergences between expected, forward, and futures prices of post-dated bonds. Since we are free to interpret the first or the second period in our two-period equilibrium conditions to be as long or as short as we please, our results readily generalize to investments of any maturity. My specific objective is to develop an efficient-market explanation of the allegedly confusing time-series behavior of the differential between the forward and futures interest rates on U.S. Treasury securities. Forward rates implicit in the term structure have been close to parallel yields on futures contracts traded on the Chicago Mercantile Exchange only for the Treasury bill contract closest to execution (Poole; Lang and Rasche). Differentials on more distant contracts have been consistently large and in 1977 reversed sign (Struble). Even allowing for transactions and carrying costs, most scholars find these events puzzling (Capozza and Cornell; Vignola and Dale). A few even interpret the persistent failure of futures and forward rates to converge as evidence of segmentation