When volatility strikes the bond markets, traders turn to interest rate futures to hedge risks or speculate on where interest rates will head. An interest rate future is a contract with an underlying instrument that pays interest. The contract is an agreement between the buyer and seller for the future delivery of any interest-bearing asset.
The interest rate futures contract lets traders lock in the price of the interest-bearing asset for a future date. They are the second most popular type of futures contract after equities.
Key Takeaways
- Interest rate futures are a financial derivative that allows exposure to changes in interest rates.
- Interest rate futures prices move inversely to interest rates.
- Investors can speculate on the direction of interest rates with interest rate futures or use the contracts to hedge against rate changes.
- Most interest rate futures that trade on American exchanges have U.S. Treasury securities as their underlying asset.
Understanding Interest Rate Futures
Interest rate futures have underlying instruments like Treasury bills with futures traded on the Chicago Mercantile Exchange (CME) or Treasury bonds with T-bond futures traded on the Chicago Board of Trade, a division of the CME. Other products such as CDs, Treasury notes, and Ginnie Mae securities are also available to trade as underlying assets of an interest rate future. The most popular interest rate futures are the 30-year, 10-year, five-year, and two-year Treasurys, as well as the eurodollar.
Participants in the futures market range from large institutional hedgers seeking to mitigate risk on interest rate exposures to speculators aiming to profit from correctly betting on the direction in which rates move. These futures contracts change hands daily on regulated commodity exchanges, settling prices based on supply and demand.
How Do Interest Rate Futures Work?
Interest rate futures are contracts that allow buyers and sellers to lock in rates on an interest-bearing asset like a government bond or interbank lending rate. Although actual delivery of these assets doesn’t occur, their value is tied to the underlying asset’s price.
For example, a common contract is the three-month eurodollar future, representing a $1 million three-month interbank time deposit starting at a future date. If interest rates go up, the value of existing bonds goes down because their fixed rates look less attractive. Similarly, eurodollar futures would then also decline in price.
Another popular interest rate future is Treasury bond futures. The underlying asset is a $100,000 face value U.S. Treasury bond with a remaining term of at least 15 years until maturity. Suppose a fund manager holds a large quantity of long-term U.S. Treasury bonds and worries that T-bond prices will decline if interest rates rise in the coming months. To hedge the risk, the manager could sell Treasury bond futures contracts, locking in prices to sell at a future date.
If interest rates do rise as expected, the prices of the manager’s Treasury portfolio would fall, but gains in their short futures position would offset that loss. This allows investors to mitigate their exposure to fluctuations in interest rates without having to sell their bond holdings.
Speculators could take the opposing view and buy futures contracts to bet that interest rates will fall. If rates decline, then Treasury bond prices rise, as do the prices of their long futures contracts. At expiration, the contracts settle in cash based on the current market price without any bonds changing hands.
Every day, gains and losses on interest rate futures are cashed out in a “marking-to-market” process. Money is debited or credited to traders’ accounts depending on how the rates they locked in compare with the latest market prices. When the contracts expire per their specified date, a final cash settlement occurs without any actual bonds or deposits changing hands.
By providing direct rate exposure in a standardized and efficiently traded vehicle, interest rate futures afford participants a useful tool to manage risks or capitalize on rate swings across the yield curve. Their unique settlement procedures make investing based on your expectations for future interest rates and can often be more convenient than transacting in the cash bond markets.
Components of Interest Rate Futures
Interest rate futures are complex financial instruments with several key components. The most relevant components include the underlying asset, expiration date, contract size, and margin requirement:
Contract size: The contract size of an interest rate future refers to the face value of the underlying asset. For instance, with Treasury bond futures, the contract size is usually $100,000 or $200,000 worth of bonds.
Expiration date: The expiration date is the specified future date upon which the contract is set to be fulfilled. The seller must deliver the interest-bearing asset to the buyer on this date. Far more often, there is a cash settlement.
Margin requirement: This is the amount of money both parties must deposit as collateral. This ensures that both the buyer and seller have sufficient means to cover potential losses and fulfill their obligations under the contract.
Underlying asset: This is typically a government bond or other debt instrument. This asset will bear a fixed interest rate that is agreed upon when the contract is made.
Interest Rate Futures Example
Treasury-based interest rate futures and eurodollar-based interest rate futures trade differently. The face value of most Treasurys is $100,000. Thus, the contract size for a Treasury-based interest rate future is usually $100,000. Each contract trades in handles of $1,000, which are split into thirty-seconds or increments of $31.25 ($1,000/32). If a quote on a contract is listed as 101'25 (or often listed as 101-25), this would mean the total price of the contract is the face value plus one handle plus 25/32 of another handle:
101′25Price=$100,000+$1,000+($1,000×3225)=$101,781.25
Eurodollar-based contracts have a size of $1 million, a handle size of $2,500, and trade in increments of $25. Unlike Treasury-based agreements, these contracts can trade at half-tick and quarter-tick values. This means that the minimum price movement of a $1 million contract is only $6.25, which equals $25 x 25%.
The price of an interest rate future moves inversely to the change in interest rates. If interest rates go down, the price of the interest rate future goes up and vice versa. For instance, suppose a trader speculates that interest rates will fall over the next month and bond prices will rise. The trader purchases a 30-year Treasury bond futures contract for 102'28. One month later, the trader's prediction is proven correct. Interest rates are lower, and the interest rate future is now priced at 104'05. The trader sells. Here's the profit:
PurchasePrice=102′28=$102,875SalePrice=104′05=$104,156.25Profit=$1,281.25or1.25%Uses of Interest Rate Futures
Interest rate futures serve a dual purpose in the financial world, acting as both a tool for speculation and for hedging against potential risks. Speculators may leverage interest rate futures to bet on the movement of interest rates, capitalizing on accurate predictions to make a profit.
Meanwhile, these futures are invaluable for hedging, particularly in managing bond portfolios or mitigating the impact of fluctuating interest rates. For example, a borrower expecting to refinance a loan in the future might use interest rate futures to lock in current rates, while an investor holding a portfolio of fixed-income securities might use them to protect against the risk of falling bond prices due to rising interest rates. This contract's value will decrease if rates rise, but the resulting profit can help counterbalance the heightened cost of their loan. This strategic use of interest rate futures allows borrowers to mitigate potential financial damage from rising interest rates.
Understanding Quotes: Handles and Ticks
For interest rate futures, quotes are typically divided into handles and ticks. The "handle" is the whole number of a price quote—the portion of the quote that appears to the left of the decimal point. For instance, a Treasury bond futures contract would have $1,000 handles. It provides a quick way to refer to the price of an asset, making communication in the fast-paced trading environment more efficient.
The "tick" refers to 1/32 of a handle. It's generally expressed in decimal points. The handle is further broken down into ticks for Treasury bonds. Understanding handles and ticks is crucial for traders as it allows them to interpret price quotes accurately and gauge the minimum price movements they can expect in the market.
Pros and Cons of Interest Rate Futures
Pros
High liquidity, ensuring easy trading.
Effective tool for hedging against risk.
Real-time price transparency enhances trading decisions.
Cons
No control over unpredictable future events.
Overleveraging can lead to significant losses.
Expiry dates present additional trading challenges.
How Do Interest Rate Futures Differ From Traditional Bond Investments?
Interest rate futures are derivative contracts that speculate on the future movements of interest rates, while traditional bond investments involve purchasing debt securities with fixed or variable interest payments. Futures allow for leverage and hedging against interest rate changes, while bonds provide regular income and return of principal at maturity.
What Are Some Common Strategies For Trading Interest Rate Futures?
These include hedging against interest rate risk, speculating on future rate movements, and spread trading, where traders take positions in different interest rate futures contracts to capitalize on changes in the yield curve. Each strategy requires a thorough understanding of interest rates and the factors that influence them.
What Role Do Interest Rate Futures Play in Monetary Policy?
Interest rate futures are used by central banks and other monetary authorities as indicators of market expectations for future interest rates. They can influence monetary policy by providing a sense of market sentiment and expectations about inflation, economic growth, and other factors that impact interest rates.
Do Interest Rate Futures Pay Interest?
No, interest rate futures themselves do not pay interest. They are a bet on or hedge against the direction of interest rates.
The Bottom Line
Interest rate futures are financial instruments that offer the advantage of hedging against interest rate changes and have high liquidity. They enable real-time price transparency, aiding in more informed trading decisions. However, they carry risks such as unpredictability from future events, potential for significant losses because of overleveraging, and challenges related to contract expiry dates. Trading in them should be done prudently in line with your investment goals and risk appetite.
