Financial Economics

Bond Futures

Published Aug 4, 2023

Definition of Bond Futures

Bond futures are financial contracts that obligate the buyer to purchase a specific bond at a predetermined price on a specified date in the future. That means they are a type of derivative instrument that is based on the underlying bond. Bond futures are traded on exchanges and are used by investors to hedge against interest rate risk or to speculate on the direction of interest rates.

Example

Assume an investor wants to buy a 10-year bond with a face value of $100,000. The current market price of the bond is $95,000. Now, the investor decides to buy a bond futures contract with a futures price of $90,000 and a premium of $5,000.

Scenario 1: If the market price of the bond increases to $100,000 before the specified date, the investor can sell the futures contract for a profit of $5,000 (the premium). The investor does not need to buy the actual bond because they only held the futures contract and not the underlying asset.

Scenario 2: If the market price of the bond decreases to $90,000 before the specified date, the investor does not incur any losses on the futures contract. They can choose to buy the bond at the futures price of $90,000, but they may also decide not to exercise the contract if it is more beneficial to buy the bond at the current market price of $90,000. They would, however, lose their premium of $5,000 in this case.

Why Bond Futures Matters

Bond futures are an important tool for investors to hedge against interest rate risk or to speculate on the direction of interest rates. They allow investors to buy or sell bonds at a predetermined price, regardless of the current market price. That means they can protect themselves from losses due to a sudden change in interest rates. In addition, bond futures are also used by institutional investors to manage their portfolios and by governments to manage their debt.