2.2. Interest Rate Futures

Short-term interest rate futures have as an underlying instrument an asset that can be borrowed or lent at short-term interest rates. This instrument may be an interest-bearing bank deposit, excess bank reserves, or (until recently) Treasury bill issues. Like other commodity futures contracts, a short-term interest rate futures contract allows the parties to lock in the current price of an underlying asset to protect against or profit from the expectation of rising or falling prices.

Interest rate futures contracts are complicated by the fact that interest rates are inversely related to the price of the assets. When interest rates rise, the market price of the underlying asset goes down. When interest rates go down, the price of the asset goes up.

Imagine that a speculator wishes to take a position in a Federal Funds futures contract. Expecting that rising interest rates will drive down the contract’s price, he will short a Federal futures contract. By selling the contract at its current high price, he will profit later