What Is an Interest Rate Future?
An interest rate future is a futures contract with an underlying instrument that pays interest. The contract is an agreement between the buyer and seller for the future delivery of any interest-bearing asset. The interest rate futures contract 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 exposure to changes in interest rates.
- Interest rate futures price move inversely to interest rates.
- Investors can speculate on the direction of interest rates with interest rate futures, or else use the contracts 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 CBOT, which is a division of the CME. Other products such as CDs, Treasury notes, and Ginnie Mae securities 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 Future Example
Treasury-based interest rate futures and eurodollar-based interest rate futures trade differently. The face value of most Treasuries is $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 (32nds), 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 trade in 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. For instance, a trader speculates that interest rates may decrease over the next month, and bond prices will fall. The trader purchases a 30-year Treasury bond futures contract for a price of 102'28. One month later, the trader's prediction has come true. Interest rates are lower, and the interest rate future is now priced at 104'05. The trader sells, and the profit is:
Purchase Price=102′28=$102,875Sale Price=104′05=$104,156.25
The Bottom Line
Interest rate futures are used for speculation purposes, but also for hedging bond portfolios or interest rates. 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 bond prices and rates. For instance, a borrower that has a loan with a variable rate will be hurt if interest rates rise. Therefore, the borrower could sell (short) an interest rate future that will fall if rates rise and gains from the short futures contract can help to offset the increased cost of the loan.