Futures on Bonds: Trading Example & Introduction: Options, Futures, Derivatives & Commodity Trading

Futures on Bonds: Trading Example & Introduction

Details about Bond Futures Trading with an example and calculations
In this article, we will cover the Bond Futures i.e. futures with an underlying as bonds. These futures can be exchange traded futures like those on NYSE or Pinksheet or can be OTC (Over the counter) between two parties on mutually agreed terms. The exchange traded bond futures may require daily settlement and movement of margin money, while the OTC bond futures may not need daily margin requirements depending upon the futures agreement.
Let's start with the basics first:
What is a Bond Future or Future on bond?
As we all are aware, a futures contract is an agreement between two parties to trade a particular asset at a fixed price on a fixed date in future.
Bond futures are those future contracts which have the underlying asset as bonds. Like any other futures contract, Bond futures have an expiry date and the futures price. On the expiry date, the buyer gives over the bonds to the seller and the seller gives over the agreed price to the buyer.
Let's see an example.
Can we have an example of Bond Futures
Yes. Let's say there are two traders - Bunny the buyer and Sunny the seller.
Assume that "US Treasury Bond 8% $100 2030" is currently trading at $99 per bond in the open market or exchange. Assume today is 1 January.
Bunny the buyer believes that in 3 months time (by 31st March), this bond will trade higher and will reach the price of $105.
Sunny the seller believes that in 3 months time, this bond will trade lower and will reach the price of $97.

So both these bond traders have opposing outlook on the same bond but for the same time period and they decide to go for a futures contract on this bond as an underlying.
Since they both have a 3 month horizon on 1 January, here are the futures contract specification:

Underlying asset - US Treasury Bond 8% $100 2030 (it's current price)
Spot Price of Unerlying - $99 (Price as of today)
Trade Date - the day on which futures contract is agreed i.e. today - 1 January
Futures Expiry Date - Date on which the actual exchange will happen - 31 March
Futures Price - Say they both agree to trade this for $101 - this becomes the futures price.
Contract Size - 100 bonds (assume they both want to trade 100 bonds)

So what will happen on Expiry date of 31st March?
Bunny will deliver 100 bonds (US Treasury Bond 8% $100 2030) to Sunny on 31 March.
In return, Sunny will give 100 * 101 $ (contract size * futures price) = 10100 USD to Bunny. Effectively, $101 per bond.

Bonds Futures Trading Explained with a Trade Example

How will this Bond Futures trade benefit either of the futures traders?
Suppose Bunny's prediction comes true. His prediction was that by expiry date, the bond prices will shot upto $105.
In this case, since the futures price they both agreed upon is $101, Bunny will benefit. He will get the bonds at the rate of $101 only and can sell it in the market at $105 to make a profit of $4 per bond.
Sunny will suffer the loss because he may either have to purchase the bonds from open market at the price of $105 and give it to Bunny for $101. OR, he may have purchased the bonds long time back at cheap price (say $95), but instead of selling them at market price of $105, he is forced to sell it to Bunny at $101 (the agreed futures price). In either case, he has to suffer the loss of $4 per bond.
Bunny profit comes at the expense of Sunny's loss.

Suppose that Sunny's rpediction comes true and by expiry date, the bond prices comes down to $97.
Sunny will now benefit, because he will get $101 from Bunny for a bond that is currently trading at $97 only. After receiving $101 from Bunny, Sunny can buy them in the open market at just $97 and make immediate profit of $4 per share.
Bunny suffers the loss because he now needs to pay $101 for something which is available at $97 in the market.
Sunny's profit come at the expense of Bunny's loss.

How does Bond Futures trading work in real life?
In realistic scenarios - no exchange actually takes place for bonds. Everything is settled in money.
Sunny does not need to provide any actual bonds to Bunny - whatever is the price differential, that is transferred to the winning party from the loosing party.
Also note that if this is an exchange traded bond future, then there can be margin requirements. Margin requirements on futures means both the parties assessing their positions at the end of each day and the loosing party providing margin money via the exchange to the winning party.
For eg, on each day between 1 January to 31 March (i.e. between trade date and expiry date), both Bunny and Sunny will have to assess their trade positions profit and loss at the end of the day. If at that end of the day, Bunny is in profit and Sunny is in loss, then Sunny needs to provide margin money to Bunny (via the exchange) to remain in the futures position).
The margin requirements are usually set by the exchanges as well as the brokers who act as intermediaries.

In case this bond future trade is over the counter or OTC, then margin money requirements may not apply on daily basis, based on the mutual agreement.

What decides the Bond Futures prices?
In case of any futures contract defined on any underlying, the price of the underlying usually decides the price of its futures.
In case of bond futures, the price of the underlying bond will be the major factor in determining the bond futures prices.
Other than that, the interest rate, risk premium, time to expiry and cost of carry are other factors which may have an influence on price of bond futures.

What is the difference between Bond Futures and Bond Forwards?
The simple difference between a forward and a future contract is that forward contract is NOT through an exchange while future usually is on an exchange.
Also, futures contract require margin money, while forwards may not.

Forward Contract Example

Forward Contract

Futures Contract Example

Futures Contract
See these images to see how a forward contract on gold will differ from a similar future contract on gold with respect to margin money & daily settlement requirements in case of futures contract (Click on images to enlarge)
Bond Futures
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