how do interest rate futures work 
interest rate futures are contracts that allow buyers and sellers to lock in rates on an interest bearing asset like a government bond or interbank lending rate although actual delivery of these assets doesn t occur their value is tied to the underlying asset s price if interest rates go up the value of existing bonds goes down because their fixed rates look less attractive another popular interest rate future is treasury bond futures the underlying asset is a 100 000 face value u s treasury bond with a remaining term of at least 15 years until maturity 4 suppose a fund manager holds a large quantity of long term u s treasury bonds and worries that t bond prices will decline if interest rates rise in the coming months to hedge the risk the manager could sell treasury bond futures contracts locking in prices to sell at a future date if interest rates do rise as expected the prices of the manager s treasury portfolio would fall but gains in their short futures position would offset that loss this allows investors to mitigate their exposure to fluctuations in interest rates without having to sell their bond holdings speculators could take the opposing view and buy futures contracts to bet that interest rates will fall if rates decline then treasury bond prices rise as do the prices of their long futures contracts at expiration the contracts settle in cash based on the current market price without any bonds changing hands 5every day gains and losses on interest rate futures are cashed out in a marking to market process money is debited or credited to traders accounts depending on how the rates they locked in compare with the latest market prices 6by providing direct rate exposure in a standardized and efficiently traded vehicle interest rate futures afford participants a useful tool to manage risks or capitalize on rate swings across the yield curve their unique settlement procedures make investing based on your expectations for future interest rates and can often be more convenient than transacting in the cash bond markets pros and cons of interest rate futureshigh liquidity ensuring easy tradingeffective tool for hedging against riskreal time price transparency enhances trading decisions no control over unpredictable future eventsoverleveraging can lead to significant losses expiry dates present additional trading challenges components of interest rate futuresinterest rate futures are complex financial instruments with several key components the most relevant components include the underlying asset expiration date contract size and margin requirement 789contract size the contract size of an interest rate future refers to the face value of the underlying asset for instance with treasury bond futures the contract size is usually 100 000 or 200 000 worth of bonds expiration date the expiration date is the specified future date upon which the contract is set to be fulfilled the seller must deliver the interest bearing asset to the buyer on this date far more often there is a cash settlement margin requirement this is the amount of money that both parties must deposit as collateral this ensures that both the buyer and seller have sufficient means to cover potential losses and fulfill their obligations under the contract underlying asset this is typically a government bond or other debt instrument this asset will bear a fixed interest rate that is agreed upon when the contract is made interest rate futures exampletreasury based interest rate futures and eurodollar based interest rate futures trade differently the face value of most treasurys is 100 000 thus the contract size for a treasury based interest rate future is usually 100 000 each contract trades in handles of 1 000 which are split into thirty seconds or increments of 31 25 1 000 32 5 if a quote on a contract is listed as 101 25 or often listed as 101 25 this would mean the total price of the contract is the face value plus one handle plus 25 32 of another handle 101 25 price 100 000 1 000 1 000 2532 101 781 25 begin aligned 101 prime25 text price 100 000 1 000 left 1 000 times frac 25 32 right 101 781 25 end aligned 101 25 price 100 000 1 000 1 000 3225 101 781 25 eurodollar based contracts have a handle size of 2 500 and trade in increments of 25 unlike treasury based agreements these contracts can trade at half tick and quarter tick values this means that the minimum price movement of a 1 million contract is only 6 25 which equals 25 25 10the price of an interest rate future moves inversely to the change in interest rates if interest rates go down the price of the interest rate in the future will go up and vice versa for instance suppose a trader speculates that interest rates will fall over the next month and bond prices will rise the trader purchases a 30 year treasury bond futures contract for 102 28 one month later the trader s prediction is proven correct interest rates are lower and the interest rate future is now priced at 104 05 the trader sells here s the profit 