An interest rate futures contract is a futures contract, based on an underlying financial instrument that pays interest. It is used to hedge against adverse changes in interest rates.
Such a contract is conceptually similar to a forward contract, except that it is traded on an exchange, which means that it is for a standard amount and duration. The standard size of a futures contract is $1 million, so multiple contracts may need to be purchased to create a hedge for a specific loan or investment amount. The pricing for futures contracts starts at a baseline figure of 100, and declines based on the implied interest rate in a contract.
For example, if a futures contract has an implied interest rate of 5.00%, the price of that contract will be 95.00. The calculation of the profit or loss on a futures contract is derived as follows:
Notional contract amount × Contract duration/360 Days × (Ending price – Beginning price)
Most trading in interest rate futures is in Eurodollars (U.S. dollars held outside of the United States), and are traded on the Chicago Mercantile Exchange.
Hedging is not perfect, since the notional amount of a contract may vary from the actual amount of funding that a company wants to hedge, resulting in a modest amount of either over- or under-hedging. For example, hedging a $15.4 million position will require the purchase of either 15 or 16 $1 million contracts. There may also be differences between the time period required for a hedge and the actual hedge period as stated in a futures contract. For example, if there is a seven month exposure to be hedged, a treasurer could acquire two consecutive three-month contracts, and elect to have the seventh month be unhedged.
When the buyer purchases a futures contract, a minimum amount must initially be posted in a margin account to ensure performance under the contract terms. It may be necessary to fund the margin account with additional cash (a margin call) if the market value of the contract declines over time (margin accounts are revised daily, based on the market closing price). If the buyer cannot provide additional funding in the event of a contract decline, the futures exchange closes out the contract prior to its normal termination date. Conversely, if the market value of the contract increases, the net gain is credited to the buyer’s margin account. On the last day of the contract, the exchange marks the contract to market and settles the accounts of the buyer and seller. Thus, transfers between buyers and sellers over the life of a contract are essentially a zero-sum game, where one party directly benefits at the expense of the other.
It is also possible to enter into a bond futures contract, which can be used to hedge interest rate risk. For example, a business that has borrowed funds can hedge against rising interest rates by selling a bond futures contract. Then, if interest rates do in fact rise, the resulting gain on the contract will offset the higher interest rate that the borrower is paying. Conversely, if interest rates subsequently fall, the borrower will experience a loss on the contract, which will offset the lower interest rate now being paid. Thus, the net effect of the contract is that the borrower locks in the beginning interest rate through the period of the contract.
When a purchased futures contract expires, it is customary to settle it by selling a futures contract that has the same delivery date. Conversely, if the original contract was sold to a counterparty, then the seller can settle the contract by buying a futures contract that has the same delivery date.