Short-Term Interest Rate Forwards and Futures: Convexity Adjustment

A convexity adjustment is required to relate STIR forward rates to STIR futures rates. Here we outline the differences between short-term interest rate forwards and futures by comparing an FRA with a Eurodollar futures contract. We show that the futures rate associated with the Eurodollar contract needs to be adjusted in order for the two contracts to be directly comparable, by looking at the daily settlement and payoffs at expiration.