The futures market enables traders to speculate on price movements by agreeing to purchase an asset at a certain price on a set date in the future. For example, a trader buying corn futures can lock-in the price of corn one year out into the future. If corn prices rise above the agreed upon price, the trader would realize a profit on the trade without ever taking physical delivery of the corn.
In this article, we’ll take a look at how traders can speculate on interest rates using interest rate futures and some considerations when making those trades.
Interest Rate Futures 101
Interest rate futures are derivatives contracts with an interest-bearing instrument, like a Treasury, as their underlying asset. For example, a one-year futures contract on a 30-year Treasury bond might be priced with a 5% yield. Traders might purchase the futures contract if they believe that interest rates will fall to 3% in a year, since the price of the bond moves inversely to the prevailing interest rate at the time
There are several different types of interest rate futures, depending on the underlying instrument being used:
- Treasury bills (“T-Bills”) are short-term futures contracts traded on the Chicago Mercantile Exchange (“CME”). T-Bills have maturity dates that are usually less than a year into the future.
- Treasury bonds are longer-term futures contracts traded on the Chicago Board of Trade (“CBOT”). Treasuries have maturity dates ranging Treasury notes, Mortgage bonds, and Certificates of Deposits (“CDs”) can be used to make similar trades. Treasury notes have maturity dates that are usually two-to-10 years out into the future.
- Eurodollars are futures contracts written on a 3-month interest vehicle denominated in U.S. dollars but deposited in offshore banks. These contracts are traded on the CME and are among the most liquid futures in the world.
Most interest rate futures, particularly Treasury securities, involve relatively high dollar amounts of $1 million or more. These dynamics keep many smaller traders out of the market, with most participants being larger sophisticated trading operations using the trades as a hedge more so than a tool for speculation. However, individual trades do have some options for placing similar bets.
Trading Interest Rate Futures
The most popular interest rate futures are the 30-year T-Bond, 10-year Note, 5-year Note, 2-year Note, and Eurodollar. Before discussing the details, it’s important for traders to understand how the Treasury markets function. The face value of most bonds is $100,000, which means that the contract sizes are also $100,000. Each contract trades in handles worth $1,000 or 1,000 points apiece.
Of course, Treasury bonds don’t trade with even handles and each tick is equivalent to 1/32 of a full point or $31.25 ($1,000 / 32). Bond quotes are therefore given in the format 101’25 or 101-25, which would mean 101 handles and 25/32nds and yield a value of $101,781.25 ($1,000 * 101 + 25 * $31.25). These calculations are important to understand in order to determine profits or losses.
The exception to the rule is the Eurodollar futures contract, which has a $1,000,000 contract size with a handle value of $2,500 and a tick value of $25.00. Unlike Treasuries, these contracts can also trade at half and quarter tick values, which adds to the complexity when calculating profits and losses. The basic contract values can be calculated by moving the decimal point and multiple each full tick by $25.00.
Quick Example of a Trade
Let’s take a look at a complete example of a trader that purchases an interest rate futures contract and sells it within a year for a profit.
Suppose that a trader believes that interest rates are going to fall and purchases a futures contract on a 30-year Treasury bond for 102’23. The cost of the trade would be $102,718.75 using the same calculation as above. Notably, the trader chose the 30-year Treasury bond in order to experience less volatility than the short-term term options available, such as the 5-year or 2-year Treasury notes.
In a little less than one year, the trader’s predictions have come true. Interest rates have fallen and the bond’s price has risen to 103’24, which implies a valuation of $103,750 using the calculation above. With the initial purchase price of $102,718.75, the trader is sitting on a profit of about $1,031.25 or a gain of a little over 1% from the trade due to the rise in underlying interest rates.
Other Considerations for Traders
Trading interest rate futures requires the ability to predict the future direction of interest rates above all else. In most cases, interest rates rise when an economy is growing and fall when an economy is faltering. Central banks are responsible for setting these interest rates in most cases, although the markets can certainly have an impact in pushing them to take monetary policy actions.
Traders should also keep a few things in mind when dealing with interest rate futures, including the following points:
- Maturity Dates Matter. The length of the bond’s maturity date is critical in determining the volatility of the trade. In general, short-term bonds are much more volatile than long-term bonds due to interest rate changes.
- Large Contract Sizes. Interest rate futures have contract sizes ranging from $100,000 to $1 million, depending on the type of bond, which could preclude smaller traders from participating in the trades.
- Quick Movements. Monetary policy decisions, such as overnight lending rates, can have a large and fast impact on interest rates, and these decisions can be quite unexpected at times, leading to higher volatility.
The Bottom Line
Interest rate futures are a great way to either hedge a portfolio against interest rate exposure or speculate on future interest rate changes. While trading these futures contracts is a bit more involved than many commodities, traders can use relatively simple calculations to determine their profits and losses. The downside is that the contracts are large in size (>$100,000) and can be quite volatile at times.