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 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.
What are interest rate futures prices? ›
Interest rates are one of the most important factors that affect futures prices; however, other factors, such as the underlying price, interest (dividend) income, storage costs, the risk-free rate, and convenience yield, play an important role in determining futures prices as well.
Where can I buy interest rate futures? ›
The two exchanges - the National Stock Exchange (NSE) and the Bombay Stock Exchange - both offer interest rate futures in India (BSE). A Demat account can be opened and traded in. The underlying securities for these futures contracts are government bonds or T-Bills.
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%.
What is interest rate futures and swaps? ›
The “swap rate” is the fixed interest rate that the receiver demands in exchange for the uncertainty of having to pay the short-term LIBOR (floating) rate over time. At any given time, the market's forecast of what LIBOR will be in the future is reflected in the forward LIBOR curve.
How to use interest rate futures? ›
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.
Why buy interest rate futures? ›
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.
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). The gain on futures can be used to offset the lower interest earned.
Can individuals buy futures? ›
An individual or retail investor who wants to trade futures must typically open an account with a futures commission merchant and post the initial margin requirement, which, in turn, is held at the exchange's clearinghouse.
What is the prediction for interest rates in 2024? ›
Mortgage rate predictions 2024
While there's some dispute on exactly how much rates will decrease, the general consensus is that mortgage rates will go down later in 2024 and end up in the mid-to-low 6% range.
After all, higher rates equate to higher minimum payments. So, you may be wondering if, and when, mortgage rates might fall to 3% or lower again - and whether or not it's worth waiting to buy a home until they do. Although rates could fall to 3% again one day, it's not likely to happen any time soon.
How high will interest rates go in 2025? ›
The median estimate for the fed-funds rate target range at the end of 2025 moved to 3.75% to 4%, from 3.5% to 3.75% in December.
Will interest rates go down again in 2024? ›
Mortgage rates may continue to rise in 2024. High inflation, a strong housing market, and policy changes by the Federal Reserve have all pushed rates higher in 2022 and 2023. However, if the U.S. does indeed enter a recession, mortgage rates could come down.
Why use swaps instead of futures? ›
In this sense, swaps can be seen as a sequence, or strip, of futures (Heckinger and Mengle (2013)). One key difference between swaps and futures, however, is that futures are highly standardized contracts, while swaps can be customized to better hedge the price risk of the commodity for the counterparty.
How do banks make money on interest rate swaps? ›
The bank's profit is the difference between the higher fixed rate the bank receives from the customer and the lower fixed rate it pays to the market on its hedge. The bank looks in the wholesale swap market to determine what rate it can pay on a swap to hedge itself.
What is the difference between interest rate futures and 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.
How do future price and interest rate correlate? ›
(i) If futures prices are positively correlated with interest rates then futures prices will exceed forward prices. (ii) If futures prices are negatively correlated with interest rates, then futures prices will be lower than forward prices.
What do futures prices mean? ›
The futures price is an agreed-upon price in a contract (called a futures contract) between two parties for the sale and delivery of the asset at a specified time later on.
When futures prices are positively correlated with interest rates? ›
If there is a positive correlation between futures prices and interest rates, a long futures contract is more profitable than comparable long forward contracts. B. If futures prices and interest rates are negatively correlated, short forward positions are more attractive than a comparable short futures contract.
What is an example of a futures price? ›
An asset can have different spot and futures prices. For example, gold may have a spot price of $1,000 while its futures price may be $1,300. Similarly, the price for securities may trade in different ranges in the stock market and the futures market.
