Abstract
This paper provides an overview of the literature on the topic of interest rate futures volatility. It begins by explaining what interest futures are and how their value depends on different factors. The article notes that despite the generally adequate ratio of risks and returns, most large companies prefer to trade stable contracts. To ensure that their investments are as safe as possible, these organizations study trading tendencies to gain an understanding of the regular causes of volatility. This allows them to predict when the market will have the least tribulations and select the optimal time to perform their operations. This paper contains a concentrated selection of the most notable relevant information available from reputable public sources.
Interest rate futures are a type of futures contract that uses an interest-bearing instrument as the underlying asset; such contracts are also known as financial derivatives. Like all futures, these contracts are an arrangement for purchasing a predefined set of securities at a specific point in the future for an agreed-upon price. When the expiration date comes, they can be settled with cash, or with one party taking delivery of the underlying asset (What Are Interest Rate Futures?, n.d.). The underlying assets could range from short-term obligations to 30-year treasury bonds.
The value of all interest rate futures always depends on the rises and falls of interest rates. However, this is not a direct correlation, as the expenses associated with delivering bonds when the contract expires can also carry noticeable changes to the price of these futures. Although higher-risk contracts have been proven to have proportionally increased returns, this type of investment is still considered unstable (Bernoth et al., 2020). The goal of this paper is to assess the volatility of interest rate futures. The analysis will be based on an overview of the recent findings that will be outlined in the following section and referenced on the bibliography page. The major points drawn from the presented information will be briefly reiterated in the results and discussion section.
Background
The topic of derivative contracts is exceptionally well developed in the finance community, and there is a sufficient amount of informative articles that cover or mention the volatile nature of interest rate futures. This section will reference the most notable findings from a broad range of academic sources. Interest rate futures are considered a highly beneficial economic phenomenon due to their standardization helping manage interest rate fluctuations (Putnam, 2015). Still, even with modern algorithmic trading systems reacting to new information faster than any human, the value changes of interest rate futures are challenging to control or predict (Frino et al., 2020). However, according to publicly available reports, interest rate futures seem to yield substantially better results from informed trading than most of the other areas of the market (Phuensane & Williams, 2018). This distinction might be the reason why many large organizations choose to become part of interest rate futures trading, either by issuing debt or by purchasing contracts expecting to receive additional profit on the date of expiry.
To operate efficiently and minimize losses, these companies research market tendencies with utmost attention in order to find trends that could grant them an advantage; some of their findings will be outlined in this section. Multiple studies have noted that the volatility of interest rate futures increases as they approach their expiration date – this is known as the maturity effect (Gurrola-Perez & Herrerias, 2018). Another article suggests that the futures market and the cash market could simultaneously affect the volatility of each other if the overall volume is low (Saldi & Chopra, 2018). It should be noted that this issue was observed in India, and is less likely to affect the developed economy of the US. The American futures market has different crucial factors, such as the liquidity of contracts for certain securities, which is often overlooked (Goss & Avsar, 2018). Another observation that might be missed by some traders is that volatility depends on time, increasing dramatically, around 2.30 pm, and falling as the day ends (Gerace & Frino, 2020). Such seemingly minor pieces of information are vital to optimizing the trading process.
Results and Discussions
Several important conclusions have been drawn from the literature examined in the previous section. The US interest rate futures market is highly advanced and possesses various hedging techniques that perform at different levels of efficiency (Mun, 2016). Since day trading is in its majority a speculative process, companies constantly research the market and analyze extensive statistical data to discover dependencies that might make their future predictions more accurate. To reduce unexpected risks, they study the futures volatility patterns to determine the best times and ways to trade. In addition to the well-known maturity effect, which explains the increase of volatility when a contract approaches its expiration date, there are less prominent observations. One of them is the fact that prices are less stable in the first trading hours of the day and become more solid later.
References
Bernoth, K., Hagen, J. von, & de Vries, C. (2020). Currency Futures’ Risk Premia and Risk Factors. SSRN Electronic Journal, 43. Web.
Frino, A., Garcia, M., & Zhou, Z. (2020). Impact of algorithmic trading on speed of adjustment to new information: Evidence from interest rate derivatives. Journal of Futures Markets, 40(5), 749–760. Web.
Gerace, D., & Frino, A. (2020). Dynamics of Interest Rate Futures: A Comprehensive Study from The Sydney Futures Exchange. SSRN Electronic Journal, 20. Web.
Goss, B. A., & Avsar, S. G. (2018). Liquidity and realized volatility in short-term interest rate futures in 2008 crisis. High Frequency, 1(1), 21–31. Web.
Gurrola-Perez, P., & Herrerias, R. (2018). Volatility term structure of interest rate futures.
Mun, K. C. (2016). Hedging bank market risk with futures and forwards. Quarterly Review of Economics and Finance, 61, 112–125. Web.
Phuensane, P., & Williams, J. M. (2018). Order Flow Toxicity and Informed Trading around Known Market Manipulation Events: Evidence from Interest Rate Futures. SSRN Electronic Journal, 63. Web.
Putnam, B. H. (2015). Interest Rate Futures: Elements of a Successful Financial Innovation (pp. 349–379). Web.
Saldi, R., & Chopra, M. (2018). Price discovery and volatility spillover between interest rate cash and futures market in India. Pranjana:The Journal of Management Awareness, 21(2), 74. Web.
What are Interest Rate Futures? (n.d.). Corporate Finance Institute. 2020. Web.