What are Interest Rate Futures?
Interest rate futures are futures contracts based on interest-bearing financial instruments. This futures contract can be cash-settled or it can involve the delivery of the underlying security. Like other futures, this is an agreement for the long position to receive the interest earned on a notional amount and the short position to pay this amount. Since the value is based on an underlying asset, an interest rate future is considered a financial derivative. The underlying asset can be any interest-bearing instrument such as treasury bills, treasury bonds or Eurodollars. These futures can be used for speculative or hedging purposes.
Quick Summary of Points
- Interest rate futures are futures contracts based on an interest-bearing financial instrument
- The contract can be cash-settled or it can involve the delivery of the underlying security
- These futures contracts can be used for hedging or speculative purposes
How do Interest Rate Futures Work?
Interest rate futures as mentioned before can have any interest-bearing security as the underlying asset. These futures contracts are a legal agreement to either deliver the interest-bearing security at expiration or settle the contract in cash. Most often, futures are cash-settled. Interest rate futures are traded on centralized exchanges and have a few specific components.
- Underlying asset – the interest-bearing security the value of the interest rate future is dependent on
- Expiration date – the date in which the contract will be settled, either through physical delivery or if it is cash settled, this will be the last cash settlement
- Size – the total nominal amount of the contract
- Margin requirement – For cash-settled futures, this is the initial amount needed to enter into the futures contract, as well as the maintenance margin that the initial margin will need to stay above
There are a number of different types of interest rate futures, depending on the underlying instrument. These futures can also be short-term or long-term. Short-term interest rate futures have an underlying instrument with a maturity of less than one year, while long-term interest rate futures have an underlying instrument with a maturity of over one year.
The contract will also specify whether it is cash-settled, or the underlying asset is physically delivered at expiration. For cash-settled futures, they are settled on a mark-to-market basis and the differences in the value are settled daily, rather than aggregated at the expiration date. Physically delivered futures contracts will not require that a specific bond be delivered. Instead, the specific requirements of the interest-bearing security will be given. This gives the short position the flexibility to deliver securities (that meet the requirements) which are cheapest to them.
What are Interest Rate Futures Used For?
Interest rate futures are most often used for hedging purposes. For physically delivered futures, this can allow an investor to lock into the interest-bearing security. At the expiration date, they will be delivered the interest-bearing security.
Interest rate futures can also be used by investors holding a long position in a bond. These investors face the risk of rising interest rates. As interest rates rise, the value of bonds will fall. Since bond futures contracts use bonds as the underlying asset, these will also fall in value as interest rates rise. Investors who are worried about a rising interest rate can sell interest rate futures to counter the loss in value of bonds they are holding.
Interest rate futures can also be used to gauge market sentiment about interest rates. If investors believe that interest rates will fall then futures contracts will take this into account and rise in price. If there is speculation that interest rates will rise then you would expect to see a fall in the price of these futures contracts. Speculators may also use interest rate futures to create a profit if they believe the interest rate will rise or fall by more than what is reflected by the futures contract.
The face value of treasury bonds is often $100,000. Interest rate futures contracts involving bonds will also often have a contract size of $100,000. Understanding how these bonds are quoted is important in determining trade value pricing. There are two parts when quoting treasury bonds. The first is the handle. A contract trades in $1,000 handles. The handle is further broken down into ticks. A tick is equal to 1/32 of a handle. Therefore a tick is equal to: $1,000 x (1/32) = $31.25.
A treasury bond quote of 101’34 or 101-34 would be equal to:
101 x $1,000 + 34 x $31.50 = $102,071
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