Futures Education

Financial Futures

Congress has authorized futures trading in financially based commodities called financial futures. Financial futures are contracts whose underlying products are financial instruments such as U.S. Treasury bonds or the Standard & Poor's 500 Index.
Like other futures, a financial futures contract represents a specific quantity of the underlying financial instrument at a market-determined price. They can be settled via cash or physical delivery, depending on the instrument. Like other futures contracts, the prices are determined by supply and demand - the supply of investment capital and the demand for a secure investment.
Today more than ever, financial markets are tied to a global framework. Money not only flows from sector to sector within the United States but from country to country as well, as investors constantly seek out investments with the highest rate of return and the lowest risk. It does not matter whether those investments are in the U.S. or China - money will flow to the place that offers the greatest return with the least amount of risk.
Financial futures are a unique breed of futures contract and face a challenge fitting the mold of a commodity when it comes to the underlying "product." Traditionally, the underlying asset is a consumable product like wheat, corn or silver. When it comes to financial futures, the underlying product is not always tangible, making it difficult to "deliver" at expiration. In some cases the underlying commodity simply changes form or ownership and in other cases it is settled in cash.

Interest Rate Futures

There is a saying in the financial markets that "interest rates rule the world." Debt and its corresponding interest rate touch every aspect of financial life from the cost of buying a home to the performance of the S&P 500 index.
As a general rule, when interest rates go up economic progress slows down. That means when the cost of financial notes or loans increases, there is a corresponding increase in the cost of doing business. When the cost of doing business goes up across an entire nation, profits and economic growth generally decrease. The opposite is also true, when interest rates fall, it becomes easier to do business and growth picks up.
In a sense, interest rates determine the cost of money. When you go to the bank for a loan, the banker will take an application to first determine if you are worthy of a loan, and to set an appropriate interest rate. The interest rate that you pay is part of the cost of using the bank's money. Since loans are a major ingredient to any business, the cost of money has a significant impact on the ultimate success of a business.
In the business world, profit is calculated by a simple formula: income minus expense equals profit (income - expense = profit). Interest payments fall onto the expense side of the equation. So if interest payments increase, the profitability of the business, all things being equal, drops. Similarly, if interest payments decrease, the profitability of the business will go up.
This same concept applies to the profitability of your personal finances as well. How much of your mortgage is interest payments? A drop in interest rates from 7% to 6% on a $200,000 home represents a $129 per month increase in monthly cash flow. Think of what that could do your finances. Now, think of what could happen in an economy if everyone had a $129 increase per month. The economy would grow!
Like all goods and services, interest rates are determined by supply and demand. A greater demand for money is likely to drive up the price of money, reflected in the interest rate. Demand for money depends on factors such as the nation's economic health, the level of government borrowing to support budgets, and societal perception of inflation.
A nation's central bank is the pivotal cog in setting interest rates. Since most of the country's financial institutions borrow funds from the central bank, the central bank has a great power in controlling both the supply of money and the most basic interest rate in the economy, the federal funds rate. The central bank uses interest rates to influence the economy rates are adjusted upward in an attempt to slow the economy, while rates are adjusted downward to stimulate the economy.
Commercial loans are the retail market of the lending industry. There is little if any standardization in the retail loan market - that is, retail loans are structured with varying maturity dates and interest rates are determined by the credit worthiness of the consumer.

Government Loan Market

The other side of the loan market is the government loan market. The government is one of the largest lenders and borrowers in the economy. As opposed to the retail loan market, the government loan market is highly standardized both in terms of time to maturity and interest rate. The government sets its own interest rates through the Federal Reserve System.
There are two factors common to every government loan: time, also called maturity, and interest rate, which is also called the coupon rate. Today's interest rate market is broken down into short- and long-term time frames. The short-term markets are comprised of 2-year U.S. Treasury Notes, Eurodollars, 30-day Fed Funds, and 1-month LIBOR futures. The long-term market includes the 5-year and 10-year U.S. Treasury Notes, as well as Bonds extending out to 30 years.
Before we get too deep into the analysis of the interest rate market, let's make sure we understand the underlying "commodities" that comprise the interest rate futures market.
Interest rate futures are generally based on government loan instruments. The following describes the most common interest rate futures.

Treasury Bills – 3 & 6 Months

Three- and six-month Treasury Bills are the shortest-term instruments issued by the Treasury Department. Treasury bills (or T-bills) have maturities of one year or less. T-bills do not pay interest prior to maturity; instead they are sold at a discount to the par value, where the par value is the total amount paid back to the lender at the expiration of the loan. If the par value of a 1 year T-bill is $1,000, it may be sold for $900 giving the buyer a positive yield of 11% (the loan was purchase at 900 sold for 1,000, giving the buyer a 11% ROI). Many regard Treasury bills as the least risky investment available to U.S. investors. Treasury bills are sold by single price auctions held weekly. Banks and financial institutions, especially primary dealers, are the largest purchasers of T-bills. Futures trading in T-bills has decreased dramatically recently and is not as liquid as other interest rate futures.

Treasury Notes – 2, 5 & 10 Years

Next in longevity are the Treasury notes with maturities of 2, 5 and 10 years. Treasury notes are issued in denominations of $100 to $1,000,000 and the treasury pays interest on the notes every six months. The 10-year Treasury note has become the security most frequently quoted when discussing the performance of the U.S. government-bond market and is used to convey the market's take on longer-term macroeconomic expectations.

Treasury Bonds – 10 to 30 Years

Treasury bonds are the longest-term instruments issued by the Treasury Department with maturities of 10 to 30 years. Like Treasury notes, interest on Treasury bonds is paid semiannually. The secondary market in Treasury bonds is highly liquid, so the yield on the most recent T-bond offering was commonly used as a proxy for long-term interest rates in general. This role has largely been taken over by the 10-year note, as the size and frequency of long-term bond issues declined significantly in the 1990s and early 2000s.

Eurodollar

The Eurodollar is simply a U.S. dollar that has been deposited in a bank outside the U.S., typically in London. The Eurodollar market began in the late 1950s as a way to avoid domestic banking regulations and has grown significantly since. In fact the 3-month Eurodollar is currently the most actively traded futures contract in the world.

1-Month LIBOR

One final instrument that we need to mention is the 1-month LIBOR, which uses the nominal bank deposits as its underlying "commodity." The 1-month LIBOR tracks the interest rates of the deposit of 3 million Eurodollars. This relatively new futures market provides vehicles for hedging short-term interest rate exposure, effectively filling a niche in the spectrum of interest rate risk.
One method traders use to help understand the trend of the interest rate futures market is to compare the interest rates of long-term loans (government bonds) to the interest rates of short-term loans (Eurodollars and LIBOR).

The Yield Curve

The relationship between the interest rates of short- and long-term loans is called the yield curve and interest rate traders look for a set relationship in the yield curve to help them determine the direction of future interest rates.
In general financial terms, an investment's yield is also called its rate of return. Generally, investments with a longer term have a higher yield. This is because lenders want to be paid for the opportunity cost of lending money. The longer the time frame the greater the opportunity cost. Investments with a shorter term generally have a smaller yield. Again, the opportunity cost of lending over a short period of time is not as great as over the long term.
If you to compare the yield of each of the previous instruments by plotting time on a horizontal axis and yield on a vertical axis, you would typically see a positive sloping line or curve. The yield on the 1-month LIBOR would be smaller than 30-year Treasury bond yields, and Treasury note yields would fall somewhere in between. The following graph shows the comparable yields of different instruments and is commonly referred to as the yield curve.
When short-term yields are above the long-term yields, the curve is described as being inverted. This phenomenon happens when investors believe that the long-term rates are about to fall sharply. In an effort to lock in high paying interest rates, they buy up bonds, pushing bond prices higher and causing yields to drop.

Bond Prices and Interest Rate Yield

Before we go further, there is an important relationship that you need to understand between the price of a bond and its yield: bond prices and bond yields are inversely correlated. When bond prices go up, yields come down. When bond prices go down, yields go up. This is important to understand because interest rate futures express the value, or price, of the underlying instruments - NOT the interest rate or yield.
If you expect interest rates to increase and want to profit from the pending move, you would want to short interest rate futures. Rates are going up: prices of bills, notes and bonds will go down. Similarly, if you expect interest rates to drop, you would buy interest rate futures.
Interest rate futures contracts are traded using a price index, which is derived by subtracting the futures' interest rate from 100.00. For instance, an interest rate of 5.00 percent translates to an index price of 95.00 (100.00 - 5.00 = 95.00).
The design of most interest rate futures contracts features a minimum price move, or "tick" of 0.01. Gains or losses can be easily calculated by taking the total movement in ticks and multiplying it by the tick value. For the first four quarterly and two serial Eurodollar and T-bill contracts, as well as all LIBOR contracts, the minimum tick is .005 and the tick value is $12.50. Thus a price move of from 95.005 to 95.01 would mean a gain of 1 tick or $12.50 for the long position and a loss of 1 tick or $12.50 for a short position.