Futures represent a contractual agreement to buy or sell a financial instrument or commodity at a fixed price on a fixed future date. Futures differ from forward contracts in that they are traded on an exchange while forwards are contracts between two parties. A crucial difference between an option and a future contract is that returns for the participants of futures contracts are symmetric.
These are contracts to buy or sell interest-earning assets, at a predefined level of interest rate at a future date. In most cases these assets take the form of government securities. There are two types of US$ futures contract, Treasury-bill (T-bill) futures and Eurodollar futures. T-bill futures provide a contract to buy short-term US government paper while Eurodollar futures are based on short-term time interbank deposit rates. When interest rates fall the value of interest rate futures contracts rises.
I shall use an example based on our 15-year government bond, currently trading at $7453 and a 90-day futures contract priced at $7500. If we buy the contract then in three months’ time we are committed to buying the bond at that price.
If the bond’s price is $7500 (including accrued coupon payment) then neither the seller nor the buyer of the contract will make any profit or loss. If, however, the price of the bond is above that of the futures price the buyer of the contract will make a profit and the seller a matching loss. If, on the other hand, the price of the bond falls then the situation is reversed. The seller will make a profit and the buyer a loss.
The gains (losses) on the bond are exactly compensated by the losses (gains) on the futures contract.
The symmetry of returns means that no premium is involved. Both parties are, however, potentially exposed to counterparty risk. At the end of each day each members’ contracts are marked to market. Where a member’s net position is at a loss they are required to make a matching deposit with the exchange to cover those potential losses. Exchange members are also required to contribute to an exchange fidelity, or insurance fund, to further reduce risk.
It is worth noting that no cash payments are involved even if interest rates rise and we have a loss on our futures contract. This is because the bond can be used to meet the margin requirement. Futures contracts do not exist for all issues or for all maturities. If this is the case a close equivalent has to be used. This will result in a partial hedge.
When interest rates fall the value of interest rate futures contracts rises. The buyers of interest rate futures contracts effectively lengthen net duration while the sellers shorten duration.