Bond Futures

Definition of Bond Futures

Bond futures are derivative contract that obligates the purchaser or contract holder to sell the bond on a predetermined date and time. The contract limits the contract holder’s liability to complete the transaction at the specified date and time. The bond future is traded on the futures exchange market, and buying and selling happen through the brokerage firm offering the contract.

Explanation

Bond futures, as stated earlier, are traded on the futures contract stock exchanges; the term of the contracts, including price and expiration date, is decided at the time of the buying and selling of the contracts. In simple terms, it is an agreement between a buyer and seller of the contract, where they agree to complete the transaction at a set price and predetermined time.

The contract obligates the bond futures holder to sell it at a predetermined price and date. These bond future contracts help investors bet on the bond price and help hedgers use it to protect bond holdings. They are used for trading on or hedging the interest rate movement.

Features of Bond Futures

Different features are as follows.

• It is used for hedging the existing portfolio from adverse interest rate movement.
• Bond futures are bought and sold on regulated futures stock exchanges.
• The interest rate movement of the bond futures will depend on the underlying asset/ bond.
• It obligates the bondholder to sell the bond at a predetermined price and time.

How to Get Bond futures?

To get the bond futures, an investor will have to do the following:

• Get a registration as a client with an authorized JSE interest rate and currency deviation member.
• The investor will have to deposit the initial amount as a client at the time of registration.
• After completing the above steps, the investor can buy or sell the bond future as per their needs.

Example of Bond Futures

Let us take an example where a trader purchased a bond future contract for the term of 2 years; the face value is $80,000, which will be paid at the time of expiration, and the initial deposit was $4000 to facilitate the trade. The bond’s current price is $40, equating to a $160,000 future position.

At the expiration date, the value of the bond goes down, and the bond is priced at $38 now, i.e., $152,000. This means that the trader will bear the loss of $8,000. The difference in the price is cash-settled, i.e., through the investor’s brokerage account.

Valuation of Bond Futures

The valuation of the bond futures is calculated as below:

Calculation of the price of the Bond future at the expiration date:

Bond futures price multiplied with conversion factor + accrued interest

Wherein,

• A conversion factor is a factor that is used to equalize the differences that exist between coupon amount and accrued interest in the case of delivery bonds.
• Accrued interest refers to the amount of interest earned on the bonds that are not yet paid and will be paid in the future.

Qualifying Factors of Bond Futures

Qualifying factors are as follows:

• The investor will have to pay an initial margin which varies from broker to broker.
• Though the exchange sets the initial minimum deposit requirement, it varies from broker to broker depending upon the investor’s type of bond and credit worthiness.
• The interest is earned daily on the margin held by the exchange.
• No other limit applies to individuals, foreigners, and corporate entities. But the investor should talk to their broker about the qualifying factors.

Advantages

• It gives investors a similar exposure to interest rates as a typical Bond investment at a lesser cost.
• It helps investors speculate over the price and interest rate movement for the future settlement date.
• The price fluctuation allows the traders to earn big profits many times.
• They are traded on stock exchanges and, thus, are easily accessible and have the feature of liquidity.
• They can hedge the existing portfolio’s adverse interest rate movements.

Disadvantages

• There is a significant risk due to the initial margin and fluctuation in the bond prices.
• The broker might make a margin call if the losses on the bond exceed the initial funds deposited by the investor.
• The buyer and seller’s risk of loss is unlimited because the price may fluctuate significantly.

Conclusion

It contractually obligates the contract holder to buy or sell the bond on a specified date and predetermined price. Bond futures are for investors who want to protect or hedge their existing portfolio from adverse interest rate movements and arbitrageurs who reap profit from the differential pricing of similar products in the market, for example, the price difference between spot bonds and futures. The risk associated is unlimited; therefore, investors should invest carefully after considering their risk appetite and other factors.

Recommended Articles

This is a guide to Bond Futures. Here we also discuss the definition and qualifying factors of bond futures along with advantages and disadvantages. You may also have a look at the following articles to learn more –

1. Futures vs Forward
2. Portfolio Optimization
3. Financial Assets
4. Financial Assets Types