Interest Rate and Treasury Futures Primer

Interest rate and Treasury futures allow investors to gain or hedge exposure to interest rate movements without owning the underlying bonds. These contracts are among the most liquid derivatives in the world, providing efficient tools for duration management, yield curve trades, and interest rate speculation.

Definition and Key Concepts

Treasury Futures Overview

Treasury futures are contracts on U.S. government debt securities:

Price Quotation

Treasury futures are quoted in points and 32nds:

• "110-16" means 110 and 16/32 = 110.50% of par
• For a $100,000 contract: 110.50% × $100,000 = $110,500

Tick size: 1/32 of 1 point Tick value: $31.25 for ZN, ZF, ZB (varies by contract)

Conversion Factor System

Treasury futures are physically settled, but multiple bonds can be delivered. The conversion factor adjusts prices to account for different coupon rates:

• Higher coupon bonds have conversion factors > 1.0
• Lower coupon bonds have conversion factors < 1.0
• The "cheapest-to-deliver" (CTD) bond typically drives pricing

Invoice price = Futures price × Conversion factor + Accrued interest

Duration and DV01

DV01 (Dollar Value of 01) measures the dollar change in value for a 1 basis point (0.01%) change in yield.

These values change as yields and CTD bonds change.

How It Works in Practice

Hedging a Bond Portfolio

Scenario: Portfolio holds $10 million in 10-year Treasury notes. Manager wants to reduce duration risk.

Portfolio DV01: $10,000,000 × 8.0 (duration) × 0.0001 = $8,000 per basis point

Futures DV01: 10-Year futures (ZN) DV01 ≈ $75 per contract

Contracts to hedge: $8,000 ÷ $75 = 106.7 → 107 contracts short

Hedge result: If yields rise 25 basis points:

• Portfolio loss: 25 × $8,000 = -$200,000
• Futures gain: 25 × $75 × 107 = +$200,625
• Net P/L: approximately flat

Yield Curve Trade

Scenario: You expect the yield curve to flatten (2s10s spread to narrow).

Trade:

• Buy 2-Year futures (ZT) - profits if short rates fall
• Sell 10-Year futures (ZN) - profits if long rates rise

DV01 matching: ZT DV01: ~$40 per contract ZN DV01: ~$75 per contract

To match DV01 exposure: If selling 10 ZN contracts: 10 × $75 = $750 DV01 Buy ZT contracts: $750 ÷ $40 = 18.75 → 19 contracts

Position: Long 19 ZT + Short 10 ZN

If the curve flattens by 25 bp:

• 2-year yield unchanged, 10-year yield +25 bp
• ZT P/L: ~$0
• ZN P/L: 25 × $75 × 10 = +$18,750

Worked Example

Duration Extension Using Futures

A pension fund holds $50 million in short-duration bonds (duration 2.0) but needs to match liabilities with duration 8.0.

Current portfolio DV01: $50,000,000 × 2.0 × 0.0001 = $10,000 per basis point

Target portfolio DV01: $50,000,000 × 8.0 × 0.0001 = $40,000 per basis point

DV01 shortfall: $40,000 - $10,000 = $30,000 needed

Using 10-Year Futures (ZN): Contracts needed: $30,000 ÷ $75 = 400 contracts long

Position summary:

*Futures notional = 400 × $110,000 = $44,000,000

Capital efficiency:

• Initial margin: 400 × $2,000 = $800,000
• Gains same duration exposure as buying $30 million in 10-year bonds
• Freed capital: ~$29.2 million for other uses

Performance if rates fall 50 bp:

This matches the expected P/L of an $50 million portfolio with duration 8.0: 50 × $40,000 = $2,000,000

Monitoring the Position

Risks, Limitations, and Tradeoffs

Cheapest-to-Deliver Switches

The CTD bond can change when yields shift significantly. This causes:

• Unexpected P/L as futures tracking shifts
• Basis risk between futures and your specific bond holdings
• Hedge ratio changes requiring adjustment

Convexity Mismatch

Futures have embedded optionality from the delivery choice. This creates convexity differences between futures and cash bonds, especially for:

• Ultra-long contracts
• Large yield moves
• Near delivery dates

Roll Costs

Quarterly rolls require closing expiring contracts and opening new ones. The roll spread reflects:

• Carry (coupon income vs. financing cost)
• Cheapest-to-deliver changes
• Supply/demand dynamics

Basis Risk

Futures track the CTD bond, not your specific holdings. If your portfolio holds non-CTD securities, tracking error exists.

Common Pitfalls

1. Ignoring conversion factors: Delivery involves conversion factor adjustments that affect economics.

2. Assuming static DV01: Futures DV01 changes as yields and CTD bonds change. Rebalance hedges regularly.

3. Missing roll deadlines: Treasury futures roll quarterly. Plan ahead for roll execution.

4. Confusing quotation: 110-16+ means 110 and 16.5/32, not 110.16%. Know the notation.

5. Underestimating margin: Long-duration futures have significant margin requirements that scale with position size.

Checklist for Interest Rate Futures

• Identify target duration or DV01 exposure
• Select appropriate contract (2Y, 5Y, 10Y, 30Y)
• Calculate DV01 for contract and target position
• Determine contracts needed for hedge/exposure
• Verify margin requirements and capital availability
• Understand current CTD bond and its characteristics
• Monitor basis between futures and cash holdings
• Plan quarterly roll strategy
• Set DV01 rebalancing triggers
• Track conversion factor changes near delivery

Next Steps

For commodity-specific considerations in futures, see Commodity Futures: Storage and Convenience Yield.

To understand how futures create equity exposure, review Using Futures for Equity Beta Exposure.