Futures contracts based on an interest-bearing instrument
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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.
Summary
- 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 on 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) that 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.
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 Contract
- Heath-Jarrow-Morton Model
- Stock Index Futures
- Hedging
- See all derivatives resources
FAQs
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.
What happens to futures when interest rates rise? ›
As pressure to raise interest rates rises, futures contracts will reflect that speculation as a decline in price. Price and yield will always be in an inversely correlated relationship. It is important to note that interest rate futures are not directly correlated with the market interest rates.
What is the difference between interest rate futures and bond futures? ›
Interest Rate Futures Vs Bond Futures
The main difference between Interest Rate Futures and Bond Futures is that Interest Rate Futures are linked to the movement of interest rates, while Bond Futures are based on specific bonds and used for hedging or speculating on bond prices.
When should you buy or sell interest rate futures? ›
If interest rates rise, futures prices will fall, so sell futures contracts now (at the relatively high price) and buy later (at the lower price).
What is interest rate futures and forward contracts? ›
The simplest kinds of interest rate derivatives are futures and forward rate agreements (FRAs). These two types of contracts are essentially identical; one major difference is that a futures contract is an exchange-traded contract and has fixed terms for the notional amount, length of contract, expiry date etc.
What are the disadvantages of interest rate futures? ›
Future contracts have numerous advantages and disadvantages. The most prevalent benefits include simple pricing, high liquidity, and risk hedging. The primary disadvantages are having no influence over future events, price swings, and the possibility of asset price declines as the expiration date approaches.
What are the benefits of interest rate futures? ›
Benefits of Interest Rate Futures
Trading is more transparent because prices are disseminated in real-time. These futures work well as a hedging strategy. They're also good for risk management. You can mitigate your risk of shifting interest rates as a borrower by taking an opposite position in these futures.
How do you profit from interest rate futures? ›
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.
What are the advantages and disadvantages of interest rate futures? ›
Advantages of interest rate futures
- A suitable hedging mechanism: These futures act as a good hedging mechanism. ...
- No security transaction tax: There is no security transaction tax on these futures, making them a cost-effective option.
Rising interest rates are generally bad for futures traders because they can lead to lower contract prices. However, traders who anticipate these rate increases may profit from short positions in certain futures contracts.
Interest rate futures enable banks to manage the risk of fluctuating interest rates — so they can loan money to businesses in your community and to people like you.
What will interest rates look like in 5 years? ›
ING's interest rate predictions indicate 2024 rates starting at 4%, with subsequent cuts to 3.75% in the second quarter. Then, 3.5% in the third, and 3.25% in the final quarter of 2024. In 2025, ING predicts a further decline to 3%.
Is it a good time to buy when interest rates are high? ›
Instead, they look for where is the best place to buy at the time that they have their finance ready. In fact, when interest rates are higher, you will: have less competition so can negotiate a lower purchase price. have more time to purchase the property and can shop around and conduct due diligence and research.
What will interest rates be in 2024? ›
That means the mortgage rates will likely be in the 6% to 7% range for most of the year.” Mortgage Bankers Association (MBA). MBA's baseline forecast is for the 30-year fixed-rate mortgage to end 2024 at 6.1% and reach 5.5% at the end of 2025 as Treasury rates decline and the spread narrows.
Why are futures more expensive than forwards? ›
If futures prices are positively correlated with interest rates, then futures prices will exceed forward prices. If futures prices are negatively correlated with interest rates, then futures prices will be lower than forward prices.
What is interest rate futures cheapest to deliver? ›
The term cheapest to deliver (CTD) refers to the cheapest security delivered in a futures contract to a long position to satisfy the contract specifications. It is relevant only for contracts that allow a variety of slightly different securities to be delivered.
Will the future value decrease as the interest rate increases? ›
Answer: Yes, the future value of an investment may decrease as the interest rate increases. Higher interest rates can reduce the present value of future cash flows, leading to a decrease in the investment's future value.
What causes futures to go up? ›
Many factors affect the price of futures, such as interest rates, storage costs, and dividend income. The futures price of a non-dividend-paying and non-storable asset is the function of the risk-free rate, spot price, and time to maturity.
What is the correlation between future prices and interest rates? ›
If futures prices are negatively correlated with interest rates, then it is more desirable to buy forwards than futures. If future prices are positively correlated with interest rates, then it is more desirable to buy futures than forwards.
