It’s the glue. Interest rate markets bind and are tethered to every other financial asset class from stocks to currencies. The US Federal Reserve Bank and other central banks around the globe shape and push economic growth in the short and long term. Central bank moves can tighten or expand the amount of money circulating in an economy, which then impacts the value of a currency, which then affects the value of commodities and companies – across the globe.
So you can see the power the Fed has on US markets and beyond. Interest rate futures and options contracts may be used to hedge against risks that can adversely affect portfolios or balance sheets. Yet, they also provide trading and spreading opportunities across many different markets for traders and can be some of the deepest and most liquid futures markets in the world.
These markets are primarily event-driven , meaning participants are looking for opportunities and risks in every Fed meeting, announcement, Fed speech or testimony, not to mention key economic reports from employment rates to manufacturing data.. This allows traders to go long or short across the yield curve, from 3-month Eurodollar futures and up the line to 2-year, 5-year, 10-year notes along with 30-year Treasury bond futures and Ultra Treasury bond futures.
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 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.
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 x 25/32) = $101,781.25.
Euro dollar-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 futures moves inversely to change in interest rates. If interest rates go down, the price of the interest rate future goes up and vice-versa. Assume that a trader speculates that in one year interest rate 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 = $102,875.
Sale price = 104’05 = $104,156.25.
Profit = $1,281.25 or 1.25%.