What are fixed income futures and how do they work?

A fixed income future is a type of futures contract in which investors enter into an agreement to buy or sell bonds at a predetermined price on a specified date in the future. They are typically used to either hedge or speculate on future interest rates.

In contrast to options, with futures, both the buyer (long position) and the seller (short position) by definition enter into an obligation. At the time of expiration, the buyer is obligated to purchase the underlying bonds and the seller is obligated to provide the underlying bonds. For example, Euro-Bund Futures (FGBL), which trade on Eurex, have German government bonds as the underlying. Therefore, if an investor had a long position, he or she would be obligated to buy these underlying German government bonds at expiry if the position was not closed beforehand.

There is generally an inverse relationship between interest rates in the market and the price of a fixed income future. For example, if the European Central Bank (ECB) lowers its interest rates, that means that the price of the underlying bond increases and, therefore, the price of the fixed income future increases.

Buyers and sellers of fixed income futures have differing expectations of how the value of the underlying will develop. Buyers expect a decline in interest rates and an increase in bond prices. On the other hand, sellers expect an increase in interest rates and a decrease in bond prices.

How do fixed income futures work?

In contrast to other financial products such as stocks, with futures, investors do not pay the full cash amount upfront or own the underlying asset. Instead, they deposit initial margin to enter the futures position. The amount of margin required is a percentage of the contract value.

Since only a percentage of the contract’s value needs to be put up initially, index futures are highly leveraged financial instruments. This means that slight price movements can have a large impact. When the margin requirement is higher, an investor typically needs to deposit more margin to enter the future position. This, in turn, results in lower leverage.

Futures contracts have a minimum price increment to which a particular contract can fluctuate, known as the tick size. This is determined in the specifications of the contract set by the exchange. Tick value, on the other hand, is the actual monetary amount that is gained or lost per contract per tick move and is equal to the tick size multiplied by the contract size.

How and when are fixed income futures settled?

A unique feature of futures is that they are settled daily. At the end of each trading day, the closing market price is determined by the exchange that the future trades on. This is known as the daily mark-to-market (MTM) price and it is the same for everyone. There are daily mark-to-market settlements until the expiry of the contract or the position is closed out.

The daily cash settlement is the difference between the closing price of t-1 and t. Depending on the result, the contract holder’s account is either debited or credited. For example, if at the daily settlement there has been an increase in the price of the bond, this will result in a credit to the buyer’s account and a debit to the seller’s account.

At the expiration of a fixed income future, there is usually physical delivery. This means that with a long position, an investor has the right to delivery of the underlying bonds. In contrast, other types of futures, such as index futures, are settled in cash.

ESKIMO does not facilitate the physical delivery of the underlying bonds at expiration. Investors will, therefore, need to close their position(s) before expiry. With a long position, an investor can close the position by entering an opposing order to sell the number of contracts he or she has a position in. With a short position, an investor enters a buy order for the number of contracts he or she has a position in to close it.

Where can you find information about a fixed income future?

Since fixed income futures are standardised contracts that trade on an exchange, information about the contract’s specifications can be found on the exchange’s website. Other information about the characteristics and risks of the product can be found in its Key Information Document (KID). A product’s KID can be found within the ESKIMO platform by clicking on a product’s name and then selecting ‘Documents’. The symbol and the ISIN code of a fixed income future are always unique to the relevant future.

What are the risks and rewards of investing in fixed income futures?

Trading fixed income futures can be beneficial, but it also comes with the risk of losses. It is possible to lose more than the amount that was invested. Since the price of the underlying bonds cannot sink lower than zero, the maximum loss in a long position in a fixed income future is limited to the contract value of the position. As the price of the underlying bonds can in theory rise without limits, the profit in a long position is unlimited. For short positions, the potential loss is unlimited and the profit is limited to the contract value of the position.

The information in this article is not written for advisory purposes, nor does it intend to recommend any investments. Investing involves risks. You can lose (a part of) your deposit. We advise you to only invest in financial products that match your knowledge and experience.