Interest rate futures are futures contracts in which debt obligations (e.g., bonds and eurodollars) serve as the underlying instrument or commodity.
Debt securities, such as United States Treasury notes and Bonds, are sold by an issuer as the means to raise money. The issuer of the debt is a borrower. The buyer (holder) of a debt security is a lender and expects to earn interest and have the principal returned when the debt security matures.
The issuer of debt security typically makes fixed-dollar interest payments to holders of its debt at specified times until the debt instrument matures. Debt issuers include the federal government, municipal governments and corporations.
The buyer of a US Treasury security, in effect, loans money to the US government. The buyer receives semiannual interest payments from the government. When the bill, not or bond matures, the holder receives the par value ($1 000) back from the US government as repayment of the principal. Interest rate futures contracts use US Treasury debt obligations (bonds, T-bills, and notes) as the underlying instrument or commodity.
Market value and face value
The purchaser of a debt security may hold it until it matures or may sell it any time before maturity. The market price of bonds traded in the cash market can be at, above, or below par value. It is determined by many factors, the most important of which is the relationship of the bond’s stated interest rate, its coupon rate, to current interest rates. Bond prices and interest rates are inversely related. A change in interest rates causes bond prices to move in the opposite direction. Thus, if interest rates fall, bond prices rise; if interest rates rise, bond prices fall. The market value of all bonds is subject to interest rate risk.
Treasury bills, notes, and bonds are backed by the full faith and credit of the US government, which is empowered to raise taxes and create money. T-bonds are highly liquid and can be readily converted to cash. The market price of Treasury securities changes along with overall interest rate changes (that is, they are interest rate sensitive).
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Most bonds pay a fixed amount of interest every six months. In a falling interest rate environment, previously issued bonds that pay more than prevailing rates will rise in price. To keep it simple, a five-year-old $10 000 Treasury bond with a coupon rate of 10% pays $1 000 in interest each year until maturity. If interest rates drop and new T-bonds pay 6%, purchasers of the newly issued bonds receive only $600 in annual interest, whereas the 10% bond still pays $1 000 per year.
Normal (positive) yield curve
The yield curve illustrates the relationship between bond yields and maturities. Lower yields for short-term debt and higher yields for long-term debt are typical, and the curve they produce when depicted on a graph is a normal (positive) yield curve. It has an upward, or positive, slope. The normal yield curve, as shown in the figure above illustrates the relationship between the yield for US government debt securities, ranging from one-year T-bills at 1% through 30-year T-bonds at 5%.
As I mentioned the normal yield curve has an upward slope. This is normal because of risk: the shorter the maturity, the less volatile(hence safer); the longer the maturity, the more volatile (hence riskier). The public will normally require a higher return from riskier investments.
Inverted (negative) yield curve
An inverted yield curve indicates that short-term debt securities provide higher yields than long-term debt securities. In the inverted yield curve shown in the figure, the yield on one-year T-bills is 5%, and the yields on 20-year T-bonds are 1%. Because the yield on short-term debt is higher than that of long-term debt, the yield curve is inverted. That is, the normal yield-to-maturity relationship is reversed. An inverted yield curve has a downward, or negative, slope. The inverted yield curve is usually a temporary phenomenon and occurs when the supply of money is tight.
Yield curve summary
Positive. Long-term rates greater than short-term rates
Negative. Long-term rates less than short-term rates
Flat. Long-term rates and short-term rates about the same
Humped. Short-term and long-term yields are nearly equal, and medium-term yields are higher.
Other Price-Yield Considerations
Yields on debt securities with similar maturities tend to move together. Therefore, yields (and consequently, prices) on T-bills, CDs, and eurodollar deposits – which are all short-term debt obligations – tend to move in the same direction and at the same speed. Similarly, yields on long-term T-bonds, and T-notes tend to change together.
The yield curve can change its slope and curvature, so although both long-and short-term react to similar influences, they may react with varying intensity.
Volatile short-term yields. Short-term yields are more volatile than long-term yields. Interest rates on new three-months T-bills vary from week to week, depending on economic expectations. Conversely, 20-year bond yields react less to daily events because short-term events mean little relative to the bond’s 20-year life.
Volatile Long-term prices. Long-term bond prices are more volatile than short-term bond prices. Interest rate changes have little effect on the price of short-term bills because they mature (and repay principal) quickly. Because of the long time frame and the subsequent risk to the buying power of the bond income and principal due to inflation, long-term securities have a greater interest rate risk.
Interest rate futures contracts
- contracts on short-term debt obligations,
- contracts on long-term debt obligations.
The futures contracts for short- and long-term debt have many similarities.
Short-term debt obligations
Futures contracts on short-term debt obligations include T-bill and eurodollar futures, both of which:
- have contract sizes based on $1 million par values;
- have three-month maturities;
- are priced at the discount and mature at par (100%); and
- reflect that the underlying commodity is a discount debt obligation.
Long-term debt obligations
Futures on long-term debt obligations include T-bonds and T-notes, and they each:
- have $100 000 par values;
- are treated ad having 6% coupon rates; and
- have delivery months of March, June, September, and December.
Delivery of futures on long-term debt obligation contracts can be made with qualified securities of different coupon rates. In the case of T-bonds or T-notes, the settlement price at delivery depends on the coupon rate on the bonds and adjustment factor. The amount that the long futures holder would have to pay (excluding accrued interest) is calculated as follows:
Contract settlement price X adjustment factor = amount
The adjustment factors for various deliverable Treasury issues are published by the CME using CBOT rules.
Long-term contracts are typically quoted as a percentage of par, with a tick size of 1/32 of a point or a fraction thereof. Each full point, representing 1% of the par value of the contract (1-00, or 1.00) equals $1 000. Each tick (1/32, -01 or.01) equals $31.25 change in the cash value of the contract.
T-bond futures are contracts on the longest maturity US government debt obligations. To qualify for delivery, securities must have 15 years or more remaining until maturity or the first call date. Delivery can be made by depositing the appropriate dollar amount of T-bonds in any Federal Reserve System bank for wire transfer over the Federal Reserve wire. T-bond futures are the most actively traded of all futures contracts.
T-note futures are contracts on intermediate-term US government debt. To qualify for delivery, the Treasury securities must have at least 6 1/2 years, but no more than 10 years, remaining until their maturity date or first call date. Delivery is the same as for T-bond futures.
|CME||$1 000 000||T-bills, Eurodollar||.005 = $12.50|
|CME/CBOT||$100 000||T-notes, T-bonds||1/2 of 1/32 = $15.625|
When using intermaturity spreads, which entails buying T-bill futures while selling T-bond futures, the greater volatility of long-term bond prices (rather than bond yields) must be assumed. Buying T-bill futures and selling T-bond futures may seem odd the first, but it is ok in creating an intermaturity spread.
An investor can place a dollar-weighted hedge by selling one T-bill futures contract ($1 million par) and buying 10 T-bond futures contracts ($100 000 par per contract x 10 contracts = $1 million par). With this spread weighting, if both long-term and short-term interest rates change by approximately the same amount, the change in the price of the longer-term T-bond position is greater.
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