- Financial futures are used for both hedging and speculative purposes. Bond yields and bond prices are inversely related; as bond yields rise price declines. Interest rate futures trade on the difference in price rather than yield. Financial futures, specifically interest rate futures, are used to hedge mortgage-backed securities, government debt for short term, intermediate term, and long term issuance, and interest rate swaps. The heaviest trading occurs on the Chicago Mercantile Exchange in Chicago though trading continues around the world on a nearly continuous basis.
- Every interest rate future is managed by an exchange that is responsible for regulatory and trading oversight of the product offered and the persons who trade interest rate futures. Part of the regulatory requirement is to define the contract terms for each product. For example, at the end of a trading month, contracts must be rolled to a new month or settled in cash or securities between buyers and sellers. Contract specifications define how interest rate futures may settle among bonds in the secondary market. Exchanges also regulate how much margin is required in order to trade a contract, the trading hours and days of the exchange, margin requirements, and how many futures contracts a person or company may purchase.
- Trading in interest rate futures creates great volatility. Traders may hold a fundamental view of the direction of interest rates, but traders use technical trading to chart specific points of entry and exit. Technical trading relies on price and volume patterns to pinpoint short term and intermediate trading opportunities. Technical trading uses price and volume information to create moving averages, stochastic indicators, and volume-weighted price charts for investing.
- The greatest use of interest rate futures is to hedge (or reduce) market risk on a diverse portfolio of interest rate products. For example, because the average 15- and 30-year mortgage has an expected life of about 10 years, banks, insurance companies and dealers will sell (or short) the 10-year security while owning (being long) mortgages. This maneuver will eliminate much of the market volatility of the portfolio value while allowing the portfolio manager to receive the income from the portfolio. Interest rate futures pay no interest; their only value is in the price at which they trade.
- Outstanding interest rate futures are estimated to have had over $6 trillion of value as of 2005, according to the Bank for International Settlements. Interest rate futures are used in Mexico to trade the TIIE (the Mexican interbank short-term trading benchmark), the LIBOR (or London Interbank short-term trading benchmark), the U.S. one-month interbank or federal funds rate, and the Euroyen rate which tracks the market rate for yen outside Japan. The 2-, 5-, 10- and 30-year U.S.Treasury bond contract is also very active. All are important benchmarks for determining high credit quality and liquid interest rates.
