Futures Education

Interest Rate Basics

Interest rate futures serve a major role in enabling banks to neutralize or manage their price risk. Trading interest rate futures means looking at the markets with a different perspective than banks or large commercial borrowers. The only way you will be able to make use of the interest rate futures market is to exploit the system's inefficiencies. These inefficiencies happen when large hedgers, the Fed, and other major players have different motives or objectives.
Let's assume a large corporation wants to sell a big bundle of bonds but can't find any buyers. As the corporation drops the price to try and find a buyer, the bond yields increase on the bond offering - knocking the yield out of balance with the normal yield curve. Meanwhile, another company may start dumping treasuries to raise money to buy the corporate bonds. This exacerbates the rising yield and pretty soon arbitrageurs step in to get the market back in balance.
These types of wild gyrations happen in the interest rate futures market and can create volatility. These short-term gyrations can present excellent entry points into an interest rate future. As a general rule, look for opportunities to trade the long-term issues when interest rates are falling. Also, look to stay on the shorter-term side of the curve when interest rates are rising. This will tend to keep you in the direction of the trend.
Before moving on to index futures, you should understand the basic principles behind the common interest rate hedge.

The Interest Rate Hedge

Interest rate futures can be used to hedge against an existing or future interest rate move. Hedging interest rate risk is a strategy used by banks and corporations as a way to enhance profits and ensure favorable rates over the short and long term. Depending on your interest rate outlook, a futures position can generate profits to cover (or offset) the losses associated with an adverse move in interest rates.
Remember that futures are quoted in terms of price rather than interest rate. A borrower would sell futures to protect against an interest rate rise, i.e., to profit from a decrease in the futures price, and a lender would buy futures to hedge against an interest rate decline or capitalize on an increase in the futures price.