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 is the risk of interest rate futures? ›
Interest rate futures are used to hedge against the risk that interest rates will move in an adverse direction, causing a cost to the company. For example, borrowers face the risk of interest rates rising.
What are the advantages and disadvantages of interest rate futures? ›
Benefits of Interest Rate Futures
By entering into these contracts, investors can protect themselves from adverse movements in interest rates. For example, if a company anticipates a rise in interest rates, it can take a short position in these futures to offset potential losses on its existing debt.
What is the difference between interest rate futures and FRA? ›
FRAs are typically settled in cash at the end of the contract term, with the payment based on the difference between the agreed-upon fixed rate and the prevailing market rate. Interest rate futures are marked to market daily, meaning that gains and losses are realized on a daily basis.
How do banks use interest rate futures? ›
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 is interest rate futures cheapest to deliver? ›
Cheapest to deliver (CTD) refers to the cheapest or lowest priced security in a futures contract that a seller can deliver to a buyer who holds a long position. Here's the formula to calculate the cheapest security that can be delivered: Short position: Current price of security + accrued interest.
What is the formula for interest futures? ›
IMM Index = Futures Price = 100.00 – Interest Rate. so that if the yield is 6 percent, the futures price is IMM Index – 100.00 – 6.0 = 93.00. so when the yield is 6.09 percent, the futures price is IMM Index = 100.00 – 6.09 -- 92.91.
Which is riskier futures or forward? ›
There is less oversight for forward contracts as privately negotiated, while futures are regulated by the Commodity Futures Trading Commission (CFTC). Forwards have more counterparty risk than futures.
Why do futures prices fall? ›
For traders and investors, lower futures prices or backwardation is a signal that the current price is too high. As a result, they expect the spot price will eventually fall as the expiration dates of the futures contracts approaches. Backwardation is sometimes confused with an inverted futures curve.
Why trade interest rate futures? ›
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.
While the cash market offers immediacy, the futures market provides avenues for hedging and speculation. Choosing the right market depends on one's financial goals and risk appetite.
Why futures are better than equity? ›
Futures and derivatives help increase the efficiency of the underlying market because they lower unforeseen costs of purchasing an asset outright. For example, it is much cheaper and more efficient to go long in S&P 500 futures than to replicate the index by purchasing every stock.
What is the fair value of interest rate futures? ›
Fair value (FV) is equal to the interest that could be earned on the index (i.e., cost of carry) minus the relevant stock dividends occurring during the futures' duration, which is the time from the given date (which is usually today and, for this web page, is the "for" date listed under the page title) until the ...
How to value interest rate futures? ›
The futures price for short-term interest rate futures is given by (100 – yield), where yield is expressed in percentage terms. There is a price difference between interest rate futures and forward rate agreements (FRAs) due to convexity bias.
Why sell an FRA? ›
The buyer of an FRA hedges against rising interest rates at a future date (i.e. counterparty paying a fixed rate), while the seller hedges against falling interest rates (i.e. counterparty receiving a fixed rate).
What is the expected interest rate future? ›
In its July Mortgage Finance Forecast, the Mortgage Bankers Association predicts that mortgage rates will fall from 6.8% in the third quarter of 2024 to 6.6% by the fourth quarter. The industry group expects rates will fall to 6% at the end of 2025 and will average 5.8% in 2026.
What is Fed Fund rate futures? ›
Fed Fund futures contracts are based on the EFFR rate as reported by the FRBNY. Contracts are listed monthly, extending 36 months or three years out on yield curve. Fed Fund futures are traded in IMM index terms, that is, as a price rather than a rate. The price is simply the implied rate subtracted from 100.
What is interest rate futures carry? ›
In interest rate futures markets, it refers to the differential between the yield on a cash instrument and the cost of the funds necessary to buy the instrument. If long, the cost of carry is the cost of interest paid on a margin account.
What is the interest rate futures implied rate? ›
The implied rate is an interest rate equal to the difference between the spot rate and the forward or futures rate. The implied rate gives investors a way to compare returns across investments. An implied rate can be calculated for any type of security that also has an option or futures contract.
