Interest Rate Futures and the First Cash Settled Contract

CBOT:ZB1!   T-Bond Futures
CME: Eurodollar Futures (CME:GE1!), CBOT: Treasury Bond Futures ( ZB1! )

This is the second installment of the Holidays series “Celebrating 50 Years of Financial Futures.”

Before 1970, commercial banks did business by accepting short-term deposits at low regulated rates and offering longer-term business and personal loans at higher rates.

Double-digit inflation changed all that. Federal Reserve eliminated interest rate ceilings on time deposits under 3 months in 1970, and on those over 3 months in 1973. Banks incurred huge loss from a negative spread with deposit rate higher than loan rate.

Fast forward to 2022, we find ourselves in a high inflation and an inverted yield-curve environment again. The overnight Fed Funds rate (4.00%) is nearly 500 basis points higher than the 10-Year Treasury Note (T-Note) yield (3.51%) as of December 4th.

Rising interest rates increase the financing cost from businesses to households alike. The Fed’s six consecutive rate hikes from March to November 2022 contributed to significant drawdown in the value of stocks, bonds, and commodities.

If you bought $100,000 of Treasury bonds (T-bonds) in January, its market value could drop as much as 30% with bond yield jumping to 3.5% from 1.5%. If you owe $10,000 in credit card debt, monthly interest rate charge could run up to 25% a year from 15%.

Like foreign exchange, interest rate is not a physical commodity. It is a right to holders of an interest-bearing product, and a liability to its issuer. The above examples show that both buyer and seller could have large financial exposure to changes in interest rates.

To hedge interest rate risks, futures contracts were invented in Chicago futures markets, namely, Chicago Board of Trade (CBOT) and Chicago Mercantile Exchange (CME).

CBOT Ginnie Mae Futures
Government National Mortgage Association is a US government supported entity within the Department of Housing and Urban Development (HUD). The nickname “Ginnie Mae” come from its acronym GNMA.

GNMA issues Ginnie Mae certificates, a type of mortgage-backed passthrough securities. Investors receive interest and principal payments from a large pool of mortgage loans. Since timely payments are backed by the full faith and credit of the US government, Ginnie Mae bonds are considered default risk free and have an AAA credit rating.

Although they are free from default risk, holders of Ginnie Mae bonds are exposed to interest rate risk, as bond price moves inversely with bond yield. Sensing the need from savings and loans, mortgage bankers, and dealers of mortgage-backed securities, CBOT launched Ginnie Mae Bond Futures in October 1975.

This was the first time a futures contract was based on an interest-bearing instrument. At contract expiration, futures buyers would receive actual Ginnie Mae bonds from futures sellers. While the Ginnie Mae contract has since delisted, it paved the way for the successful launches of other interest rate futures contracts in the 1970s and 1980s.

CME Treasury Bill Futures
Treasury bills (T-bills) are short-term securities issued by the US Treasury to help finance the spending of the federal government. New T-bills with maturities of thirteen, twenty-six, and fifty-two weeks are issued on a regular basis. The secondary market for T-bills is active, making them among the most liquid of money market instruments.

In May 1972, the International Monetary Market (IMM) division of the CME launched foreign exchange futures, the first financial futures contract. In January 1976, the IMM listed futures contract on 90-day (13-week) T-bills. It was the first futures contract for a money market instrument. Nobel laureate Milton Friedman rang the opening bell on T-Bill Futures launch day.

Upon maturity, seller is required to deliver T-bills with a $1 million face value and thirteen weeks left to maturity. Contracts for delivery in March, June, September, and December are listed. At any one time, contracts for eight different delivery dates are traded.

T-bills do not pay explicit interest. Instead, they are sold at a discount to redemption value. The difference between the two prices determines the interest earned by a buyer. T-bill yields are quoted on a discount basis. Futures contracts are quoted on an index devised by the IMM, by subtracting the discount yield from 100. Index values move in the same direction as T-bill price. A rise in the index means that the price of a future delivered T-bill has risen. The formula for calculating the discount yield is:

Discount Yield = ((Face Value - Purchase Price) / Face Value) X (360 / Days to Maturity)

CBOT Treasury Bond Futures
In August 1977, CBOT launched futures contracts on the T-Bonds.

At the time, the birth of T-bond futures hardly seemed like a breakthrough. Financial futures were still in their infancy. Soybeans and corn were king in the CBOT trading pit.
But all that changed in October 1979 when the Fed moved to strangle runaway inflation with a revised credit policy. The Saturday night massacre, as it was dubbed, ended decades of interest-rate stability. Interest rates bounced like a Ping Pong, affected by money supply, world events and inflation. Trading of T-Bond futures took off like a rocket.

In addition to the traditional T-Bond futures (ZB) with 15-year maturity, CBOT also lists a 20-Yr T-Bond futures (TWE) and an Ultra T-Bond (UB) with 30-year maturity. In the Mid-curve, the T-Note suite includes 2-Yr Note (ZT), 3-Yr Note (Z3), 5-Yr Note (ZF), 10-Yr Note (ZN), and Ultra 10-Yr T-Note (TN).

On December 2, 2022, daily volume of the first T-Bond futures was 388,370 contracts, while open interest reached 1,170,800 contracts. Daily volume of all CME Group interest rates futures and options contracts (IR) reached 13,786,454 lots, contributing to 54.1% of Exchange total. IR open interest was 78,244,297 lots, representing 70.4% of Exchange total.

Cash Settlement Comes to Futures Market
Up until now, futures contracts were settled by physical delivery of the underlying commodities.
• Buyer of 1 CME Live Cattle may pick up 35 cows (40,000 pounds) from Union Stockyard in Chicago southside or take delivery at a cattle auction in Wyoming.
• Seller of 1 CBOT Soybean contract would ship 5,000 bushels of the grain to a licensed grain elevator in Illinois, Iowa, or Kansas.
• For CME Pork Bellies, settlement may involve title changes of warehouse receipt from seller to buyer for 40,000 pounds of the frozen meat in a cold storage.

Even financial futures required physical delivery at that time.
• For British Pound/USD contract, it is £62,500 in pound sterling.
• For Ginnie Mae contract, it is $10 million worth of Ginnie Mae certificate.
• T-Bond futures calls for delivery of treasury bonds with face value of $100,000 and maturity of no less than 15 years.

As we discussed in “The Bogeyman in Financial Contracts”, there is inherent risk in the physical delivery mechanism. No matter how robust its original design is, industry evolution could outgrow capacity, rendering delivery failure under extreme market conditions.

In December 1981, CME launched Eurodollar futures, the first contract with cash settlement feature. Cash settlement alone can be viewed as a financial revolution. Why?
• It significantly reduces transaction cost, which in turn enhances the risk transfer or hedging function in futures.
• It allows non-commercial users to participate in futures. Broader participation improves liquidity, and the price discovery as well as risk management functions.

CME Eurodollar Futures
Eurodollars are dollar-deposits held with banks outside of the US. There are two types of Eurodollar deposits: nontransferable time deposits and certificates of deposit (CDs). Time deposits have maturities ranging from 1 day to 5 years, with 3 months being the most common. Eurodollar CDs are also commonly issued with maturities under a year.

Technically, buyer of Eurodollar future contract is required to place $1,000,000 in a 3-month Eurodollar time deposit paying the contracted interest rate on maturity date. However, this exists only in principle and is called a “Notional Value”. Cash settlement means that actual physical delivery never takes place; instead, any net changes in the value of the contract at maturity are settled in cash on the basis of spot market Eurodollar rates.

Unlike T-bills, Eurodollar deposits, the underlying of Eurodollar futures, pay explicit interest. The interest paid on such deposit is termed an add-on yield because the depositor receives the face amount plus an explicit interest payment when the deposit matures. In the case of Eurodollar, the add-on yield is the London Interbank Offered Rate (LIBOR), which is the interest rate at which major international banks offer to place Eurodollar deposits with one another. Like other money market rates, LIBOR is an annualized rate based on a 360-day year. Price quotations for Eurodollar futures are based on the IMM Eurodollar futures price index, which is is 100 minus the LIBOR.

In the following four decades, all financial futures are designed with cash settlement. Eurodollar futures paves the way for equity index futures, which were launched in February 1982 at Kansas City Board of Trade (KCBT) and April 1982 at CME.

Without cash settlement, can you imagine how to deliver 500 different stocks on a market-weighted basis for the S&P 500 futures? Or 2,000 stocks for the Russell 2000?

Happy Trading.

*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.

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