What Is an Interest Rate Future?
An interest rate future is a futures contract with an underlying instrument that pays interest. An interest rate future is a contract between the buyer and seller agreeing to the future delivery of any interest-bearing asset. The interest rate future allows the buyer and seller to lock in the price of the interest-bearing asset for a future date.
- An interest rate future is a financial derivative that allows the holder to benefit from changes in interest rates.
- Investors can speculate on the direction of interest rates with interest rate futures, or else use them to hedge against changes in rates.
- Most interest rate futures that trade on American exchanges use U.S. Treasury securities as the underlying asset.
Understanding Interest Rate Futures
An interest rate future can be based on underlying instruments such as Treasury bills in the case of Treasury bill futures traded on the CME or Treasury bonds in the case of Treasury bond futures traded on the CBT. Other products such as CDs, Treasury notes and Ginnie Mae are also available to trade as underlying assets of an interest rate future. The most popular interest rate futures are the 30-year, 10-year, five-year and two-year Treasuries, as well as the Eurodollar. Interest rate futures are used for hedging purposes and speculation purposes.
While speculators can use interest rate futures to bet on the direction of rate changes, hedgers can also use them to mute the effect of an unfavorable move in rates. For instance, a borrower that has a variable rate loan will be hurt if interest rates rise. Therefore, the borrower could buy an interest rate future that will gain if rates rise and offset the increased cost of the loan.
Interest Rate Future Example
Treasury-based interest rate futures and Eurodollar-based interest rate futures trade differently. The face value of most Treasuries are $100,000. Thus, the contract size for a Treasury-based interest rate future is usually $100,000. Each contract trades in handles of $1,000, but these handles are split into thirty-seconds, or increments of $31.25 ($1,000/32). If a quote on a contract is listed as 101'25 (or often listed as 101-25), this would mean the total price of the contract is the face value, plus one handle, plus 25/32s of another handle, or:
101′25 Price= $100,000+$1,000+($1,000×3225)
Eurodollar-based contracts have a contract size of $1 million, a handle size of $2,500 and increments of $25. These contracts, unlike Treasury-based contracts, also can trade at half-tick and quarter-tick values. This means that the minimum price movement of a $1 million contract is only $6.25, which equals $25 x 25%.
The price of an interest rate future moves inversely to the change in interest rates. If interest rates go down, the price of the interest rate future goes up and vice-versa. Assume a trader speculates that in one-year interest rates may decrease. The trader purchases a 30-year Treasury bond future for a price of 102'28. One year later, the trader's prediction has come true. Interest rates are lower, and the interest rate future he holds is now priced at 104'05. The trader sells, and his profit is:
Purchase Price=102′28=$102,875Sale Price=104′05=$104,156.25