What are Bond Futures
Bond futures are financial derivatives which obligate the contract holder to purchase or sell a bond on a specified date at a predetermined price. A bond future can be bought in a futures exchange market and the prices and dates are determined at the time the future is purchased.
BREAKING DOWN Bond Futures
A futures contract is an agreement entered into by two counterparties, where one agrees to buy, and the other agrees to sell an underlying asset at a predetermined price on a specified date in the future. On the settlement date of the futures contract, the seller is obligated to deliver the asset to the buyer. The underlying asset of a futures contract could either be a commodity or a financial instrument, such as a bond. Bond futures are contract agreements in which the asset to be delivered is a government bond.
Bond futures are standardized and liquid financial products which are traded on an exchange. The bond contract is used for hedging, speculating, or arbitrage purposes. When two counterparties enter into a bond futures contract, they agree on a price at which the party on the long side will purchase the bond from the seller who has the option of which bond to deliver and when in the delivery month to deliver the bond. A party who is short, say a 30-year Treasury bond, must deliver a Treasury bond with at least 15 years to maturity. The bonds that are typically delivered are the Cheapest to Deliver (CTD) bonds which are delivered on the last delivery date of the month.
The bonds that can be delivered are standardized through a system of conversion factors calculated according to the rules of the exchange. The conversion factor is used to equalize coupon and accrued interest differences of all delivery bonds. Therefore, if a contract specifies that a bond has a notional coupon of 6%, the conversion factor will be less than 1 for bonds with a coupon less than 6%, and higher than 1 for bonds with a coupon higher than 6%. Before trading in a contract ensues, the exchange will announce the conversion factor for each bond. A conversion factor of 0.8112 means that a bond is approximately valued at 81% as much as a 6% coupon security.
The price of bond futures can be calculated on the expiry date as:
Price = (Bond Futures Price x Conversion Factor) + Accrued Interest
The product of the conversion factor and the futures price of the bond is the forward price available in the futures market.
A bond futures contract can be held until maturity, and it can also be closed out before the maturity date. If the party that established a position closes out before maturity, s/he will record a profit or a loss from his or her position. Each day, prior to expiration, the long and short positions in the traders’ accounts are marked to market. For example, say a US Treasury bond futures contract is entered into today. When interest rates increase, bond price decreases, and vice versa. If interest rates increase tomorrow, the value of the T-bond will decrease. The account of long futures holder will be debited to reflect the loss on his end, while the account of the short trader will be credited since she profits from the price move. Conversely, if interest rates fall instead, bond prices will increase and the long trader’s account will be marked to a profit and the short account will be debited.
Bond futures are overseen by a regulatory agency that ensures a certain level of equality and consistency. However, this form of derivative can be risky because it involves trading at a future date with only current information. The risk is potentially unlimited, for either the buyer or seller of the bond because the price of the underlying bond may change drastically between the exercise date and the initial agreement.