What are Interest Rate Futures?

John Lister
John Lister
Businessman with a briefcase
Businessman with a briefcase

Interest rate futures are a financial agreement that is based around predicting the investment rate on a particular date. They differ from some other forms of futures in that no asset changes hands and any profit is made from the agreement itself. The interest rates in question relate to investing rather than borrowing.

A futures contract is based on agreeing now to complete a financial transaction at a fixed price on a fixed future date. This price will relate to an underlying asset, and the difference between the fixed price and the prevailing market price of the asset when the deal is completed will determine which side comes off better from the deal. One or both parties will be able to sell their involvement in the contract to another party before its completion date. This may happen several times and the price paid to take over the contract will vary depending on how likely it is looking that the fixed price will prove beneficial.

Many types of futures contracts involve agreeing a sale of an asset, such as company stock. The difference with interest rate futures simply involve one side paying money to the other upon completion, with no asset changing hands. The money paid is based around the actual interest rate available through a particular investment, such as Treasury bills.

The two sides, one "buyer" and one "seller," will have agreed an interest rate and an amount to be used for calculating the final payment. This amount is known as a notional amount and is roughly equivalent to the stake money in a wager. Unlike with a traditional wager, this money doesn't physically change hands, meaning the notional amount can be much higher than the actual cash either side has on hand.

Upon the completion of the contract, the two parties will compare their agreed interest rate with the actual rate of the relevant investment on that date. The amount to be paid out is the difference between the rates multiplied by the notional amount. If the actual rate is higher than the agreed rate of the deal, the "buyer" pays the "seller;" if the actual rate is lower than the agreed rate, the "seller" pays the "buyer."

There are two main uses of interest rate futures. One is simply as a way to make a prediction and then profit if it is correct or lose out if it is wrong. The other is as a form of hedging. This means to make a small investment that will pay out if prices move in a way that hurts a larger investment, thus minimizing risk. An investor who would be hurt if a particular interest rate falls might use interest rate futures so that they will make back some of these losses if this occurs.

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