Interest Rate Futures

What are Interest Rate Futures?

Interest rate futures are futures contracts based on interest-bearingInterest IncomeInterest income is the amount paid to an entity for lending its money or letting another entity use its funds. On a larger scale, interest income is the amount earned by an investor’s money that he places in an investment or project. A very simple and basic way of computing it is by multiplying the principal amount by the interest rate applied financial instruments. This futures contractFutures ContractA futures contract is an agreement to buy or sell an underlying asset at a later date for a predetermined price. It’s also known as a derivative because future contracts derive their value from an underlying asset. can be cash-settled or it can involve the delivery of the underlying securitySecurityA security is a financial instrument, typically any financial asset that can be traded. The nature of what can and can’t be called a security generally. Like other futures, this is an agreement for the long positionLong and Short PositionsIn investing, long and short positions represent directional bets by investors that a security will either go up (when long) or down (when short). In the trading of assets, an investor can take two types of positions: long and short. An investor can either buy an asset (going long), or sell it (going short). to receive the interest earned on a notional amount and the short positionLong and Short PositionsIn investing, long and short positions represent directional bets by investors that a security will either go up (when long) or down (when short). In the trading of assets, an investor can take two types of positions: long and short. An investor can either buy an asset (going long), or sell it (going short). to pay this amount. Since the value is based on an underlying asset, an interest rate future is considered a financial derivativeDerivativesDerivatives are financial contracts whose value is linked to the value of an underlying asset. They are complex financial instruments that are used for various purposes, including hedging and getting access to additional assets or markets.. The underlying assetAsset ClassAn asset class is a group of similar investment vehicles. Different classes, or types, of investment assets – such as fixed-income investments - are grouped together based on having a similar financial structure. They are typically traded in the same financial markets and subject to the same rules and regulations. can be any interest-bearing instrument such as treasury billsTreasury Bills (T-Bills)Treasury Bills (or T-Bills for short) are a short-term financial instrument that is issued by the US Treasury with maturity periods ranging from a few days up to 52 weeks (one year). They are considered among the safest investments since they are backed by the full faith and credit of the United States Government., treasury bonds or EurodollarsInternational BondsInternational bonds are bonds issued by a country or company that is not domestic for the investor. The international bond market is quickly expanding. These futures can be used for speculativeSpeculationSpeculation is the buying of an asset or financial instrument with the hope that the price of the asset or financial instrument will increase in the future. Speculative investors tend to make decisions more often based on technical analysis of market price action or hedgingHedgingHedging is a financial strategy that should be understood and used by investors because of the advantages it offers. As an investment, it protects an individual’s finances from being exposed to a risky situation that may lead to loss of value. purposes.

How do Interest Rate Futures Work?

Interest rate futures as mentioned before can have any interest-bearing securitySecurityA security is a financial instrument, typically any financial asset that can be traded. The nature of what can and can’t be called a security generally as the underlying assetAsset ClassAn asset class is a group of similar investment vehicles. Different classes, or types, of investment assets – such as fixed-income investments - are grouped together based on having a similar financial structure. They are typically traded in the same financial markets and subject to the same rules and regulations.. These futures contractsFutures ContractA futures contract is an agreement to buy or sell an underlying asset at a later date for a predetermined price. It’s also known as a derivative because future contracts derive their value from an underlying asset. 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 marginMaintenance MarginMaintenance margin is the total amount of capital that must remain in an investment account in order to hold an investment or trading position and avoid a 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 assetAsset ClassAn asset class is a group of similar investment vehicles. Different classes, or types, of investment assets – such as fixed-income investments - are grouped together based on having a similar financial structure. They are typically traded in the same financial markets and subject to the same rules and regulations. 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 positionLong and Short PositionsIn investing, long and short positions represent directional bets by investors that a security will either go up (when long) or down (when short). In the trading of assets, an investor can take two types of positions: long and short. An investor can either buy an asset (going long), or sell it (going short). 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 hedgingHedgingHedging is a financial strategy that should be understood and used by investors because of the advantages it offers. As an investment, it protects an individual’s finances from being exposed to a risky situation that may lead to loss of value. 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 positionLong and Short PositionsIn investing, long and short positions represent directional bets by investors that a security will either go up (when long) or down (when short). In the trading of assets, an investor can take two types of positions: long and short. An investor can either buy an asset (going long), or sell it (going short). in a bond. These investors face the risk of rising interest ratesInterest RateAn interest rate refers to the amount charged by a lender to a borrower for any form of debt given, generally expressed as a percentage of the principal. The asset borrowed can be in the form of cash, large assets such as vehicle or building, or just consumer goods.. 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 speculationSpeculationSpeculation is the buying of an asset or financial instrument with the hope that the price of the asset or financial instrument will increase in the future. Speculative investors tend to make decisions more often based on technical analysis of market price action 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.

Understanding Quotes

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

Additional Resources

Thank you for reading CFI’s article on interest rate futures contracts. If you would like to learn about related concepts check out CFI’s other resources:

• Futures ContractFutures ContractA futures contract is an agreement to buy or sell an underlying asset at a later date for a predetermined price. It’s also known as a derivative because future contracts derive their value from an underlying asset.
• DerivativesDerivativesDerivatives are financial contracts whose value is linked to the value of an underlying asset. They are complex financial instruments that are used for various purposes, including hedging and getting access to additional assets or markets.
• Stock Index FuturesStock Index FuturesStock index futures, also referred to as equity index futures or just index futures, are futures contracts based on a stock index. Futures contracts are an
• HedgingHedgingHedging is a financial strategy that should be understood and used by investors because of the advantages it offers. As an investment, it protects an individual’s finances from being exposed to a risky situation that may lead to loss of value.