What are interest rate futures and how do I trade them
Investors are usually well versed in futures products linked to a financial indices or commodities. But what about interest rate futures?
As you would already know, interest rates affect the pricing of financial instruments like stocks or bonds, and it pays to monitor interest rates globally. The market now expects interest rates to continue rising, as central banks start tightening their monetary polices in view of the strong inflation numbers and economic growth, particularly the US. That means, investors can potentially turn to the futures market to hedge their positions via interest rate futures in view of future interest rate hikes.
What are interest rate futures?
Interest rate futures are standardized futures contracts where the underlying instrument or asset is interest bearing.
In a pre-set future settlement day, futures contract buyer (or an investor who is going long on an interest rate futures contract) will either take delivery of the underlying instrument (if it is physically settled), or be paid in cash if the final settlement price of the underlying financial instrument is higher than the original price the investor had transacted.
Interest bearing financial instruments such as bonds pays regular interest at fixed annual or semi-annual intervals and prices are susceptible to the rise and fall of interest rates. When interest rates rises, bonds will tend to fall in price ,as new bonds have to be issued at a higher coupon rates and investors are able to obtain higher yields, hence driving down prices of existing bonds.
Interest rates and interest bearing financial instruments are inversely related. Hence investors with a view of rising interest rates 3 months or 1 year down would go short an interest rate futures contract. Should interest rates rise at settlement day, an investor can close out his short position at a lower price, and profit from the spread as the underlying interest bearing financial instrument would have dropped in price allowing buybacks at a lower price.
Interest rate futures products offered by SGX
SGX has 4 main standardized interest rate futures products.
- 10-year full-sized Japanese Government Bond Futures,
- 10-year mini Japanese Government Bond Futures,
- Eurodollar Futures
- Euroyen (TIBOR) Futures.
The variations are mainly due to different unique underlying interest bearing financial instrument. As the name suggests, the reference price of the 10-year full sized and mini Japanese Government Bond Futures are linked to the 10-year (maturity period) Japanese Government Bonds that bears a 6% coupon rate. Eurodollar Futures contract pricing is linked to the US Dollar time deposits held outside of the US. Euroyen Futures contract pricing on the other hand is tied to time deposits denominated in Japanese yen currency held outside of Japan and settlement price is fixed based on the Euroyen Tokyo Interbank Offered Rate (TIBOR) published by Japanese Bankers Association. As the underlying instruments for SGX listed futures product suggests, investors are able to trade upon their expectations of Japanese and US interest rate directions.
Benefits and Risks of investing in interest rate futures?
Simon Teo, senior manager at Phillip Futures, explained to ZUU Online that there are 3 main benefits of investing in interest rate futures.
- Margin Trading available
- Hedge against raising cost of borrowing.
- Tools for traders to take a position on their views on the Interest Rates outlook.
“Interest rate futures are traded on margin. With margin trading, instead of paying for the full contract value, investors only need to pay a margin or a small deposit of the total contract value to trade it. In the case of Interest Rate Futures, the notional contract value is USD1 million. However, the margin require to hold 1 million dollars worth of contract is only USD500 or 0.05% of the total contract value,” said Teo.
“Interest Rates Futures are normally used as a tool to hedge against loan interest. A borrower (corporate or individual) may use Interest Rates Futures to hedge against raising loan interest in the event of a rate hike by Central banks while a lender (e.g. banks) will use Interest Rates Futures to hedge against falling lending rates when Central Banks cut rates,” he said. “Interest Rates Futures allows traders to go long or short depending on their views on the interest rates outlook. They could buy the Interest Rates Futures if they think the rate is falling or short sell if they think rates are increasing.”
What about the risks?
“Interest Rates Futures are traded on leverage, profit and loss are magnified. Therefore, it is important for investors to understanding the risk before trading,” said Teo, who added that Phillip Futures dealers provide one to one coaching sessions to educate and safeguard the interests of their clients.
How to invest in interest rate futures in Singapore?
To gain exposure to trading interest rate futures, investors must first have a futures brokerage account with a licensed broker in Singapore, like Phillip Futures. After having access to a futures brokerage account, investors and trades alike can access the market via PC or mobile platforms offered by the respective brokerage houses.
Should an investor go long on a futures contract for 10-year mini Japanese Government Bond Futures at 151, and the final settlement price is at 151.33, the investor would have gained 33 ticks of profit spread (151.33 less 151) as the minimum tick size stands at 0.01.
The profit amount based on notional of 10 million yen would be 33,000 yen which translates into around SGD400. The margin required would be around SGD1,500 and investors which successfully close out the trade would have gained an ROI of 25% in the span of 3 months to 1 year. Should the contract settled at a lower price of 147.67, an equivalent loss would be suffered by investors.
What should you take note of before you invest in interest rate futures?
“You need to understand the risk of margin trading before entering into the product,” Teo emphasised. “You should also understand the factors that will affect Interest Rate Futures prices. For example, in the U.S., the monthly Federal Open Market Committee (FOMC) meeting lead by Chair Woman Janet Yellen will discuss and provide outlook on the interest rates in the U.S. moving forward. These events will affect Interest Rates Futures directly as any hint of a rate hike/cut will move prices.”