Interest Rate Futures

Question 1

definition

Answer 1

• Allow investors to speculate on or hedge against future changes in interest rates.
• Involve the obligation to buy or sell a financial instrument at a predetermined price on a specified future date.

Question 2

four types of interest rate futures

Answer 2

• Treasury Futures
• Futures contracts based on U.S. Treasury securities
• Used to hedge against or speculate on changes in long-term interest rates.
• Eurodollar Futures
• Contracts based on the interest rate paid on U.S. dollar-denominated deposits held in banks outside the United States.
• Used to hedge against changes in short-term interest rates.
• Federal Funds Futures
• Futures contracts based on the overnight federal funds rate, which is the rate at which banks lend reserves to each other overnight.
• These contracts are used to speculate on or hedge against changes in the Federal Reserve’s monetary policy.
• Short Sterling Futures:
• Short-term interest rates for deposits in British pounds.

Question 3

uses of interest rate futures

Answer 3

• Hedging: Hedge against the risk of interest rate fluctuations. E.g. a bank expecting interest rates to rise might sell Treasury futures to offset potential losses in its bond portfolio.
• Speculation: Traders can use interest rate futures to speculate on future changes in interest rates. If a trader expects interest rates to fall, they might buy interest rate futures to profit from the anticipated price increase.
• Arbitrage: Investors can exploit price discrepancies between the futures market and the spot market for interest rate instruments to make arbitrage profits.

Question 4

3 key features

Answer 4

• Leverage: Futures contracts require only a small margin deposit relative to the contract’s notional value, providing significant leverage.
• Standardization: The contracts are standardized in terms of contract size, expiration dates, and delivery terms, which enhances liquidity and makes the contracts easily tradable on exchanges.
• Daily Settlement: Profits and losses are calculated daily, and margin accounts are adjusted accordingly.

Question 5

4 types of risk

Answer 5

• Market Risk: The value of interest rate futures can fluctuate significantly with changes in interest rates
• Leverage Risk: The high leverage associated with futures trading can lead to significant losses if the market moves against the trader’s position.
• Liquidity Risk: In volatile markets, it may be difficult to enter or exit positions without significantly affecting the market price.
• Basis Risk: The risk that the price of the futures contract does not move in perfect correlation with the underlying interest rate or instrument being hedged.