Interest Rate Futures

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An interest rate future is an exchange-traded forward contract that allows a company to lock in an interest rate for a future time period. Interest rate futures trade on the Chicago Mercantile Exchange, or CME. The standard futures contract is in Eurodollars, which are bank deposits comprised of U.S. dollars, and held outside the United States. However, the CME also offers futures contracts in a variety of other interest rate products, including 30-day federal funds, one-month LIBOR, and even Euroyen TIBOR (Tokyo Interbank Offered Rate). Most trading volume is in Eurodollar contracts. Eurodollar contracts are available for as much as 10 years into the future, though trading volumes drop off substantially after the first three years.

A Eurodollar futures contract allows the buyer to lock in the interest rate on $1 million; if the buyer wishes to lock in the interest rate on a larger amount, then he must purchase additional contracts in $1 million increments. The quoted prices are derived from a baseline index of 100, and decline in amount for periods further in the future. The difference between the baseline index and the quoted price is the interest rate on the contract.

A company can buy a futures contract through a broker. The broker will charge a fee on the transaction, and also imposes margin requirements on the company that are used to ensure that the buyer or seller fulfills the futures contract’s obligations. The initial margin requirement is calculated on the basis of the maximum likely volatility for one day. The initial margin varies from a low of 1/16th of a percent of the contract amount for three-month contracts, to two percent for ten-year treasury bonds.

The futures position represented by a contract is marked to market (valued at market rates) every day; if the most recent valuation results in an incremental loss, then the margin account is reduced, and a margin call requires the contract holder to add more funds to the margin account to bring it up to the maintenance level. If the contract holder does not respond to the margin call, the broker can close out the futures position by offsetting the contract (at the contract holder’s cost). Thus, the margin account keeps unrealized losses from accumulating, which might otherwise result in a contract default.

On the final day of the contract, the exchange prices the contract, and makes a final cash settlement of the profit or loss due to or from the company.

An interest rate future is a standard contract, with a standard value, term, and underlying instrument; thus, its terms may vary somewhat from the amount of a company’s borrowings. This means that there is likely to be an imperfect hedge, which means that the company utilizing a futures contract must still carry some amount of risk.