Interest Rate Futures

Abstract

a forward market. Whereas futures contracts are traded on federally designated contract markets, forward contracts are not. Each commodities exchange maintains a clearinghouse that reconciles all trades executed on the floor of the exchange. The clearinghouse interposes itself in the middle of each transaction, becoming the buyer to every seller, and the seller to every buyer. The contractual obligation of each market participant, therefore, is to the clearinghouse, eliminating the need for market participants to concern themselves with the identity or credit standing of the other party to the transaction. Members of the clearinghouse post margins on their contracts, similar to performance bonds, to ensure the financial integrity of the market. Each day the accounts of the clearing members are adjusted as to gain or loss. Losses posted to an account must be eliminated by the deposit of cash prior to the opening of trading the following day. In contrast, forward markets generally do not require margin deposits or daily settlement is the sale of a futures contract today as a temporary substitute for the sale of the actual instrument in the future. By using a short hedge, the loss on the actual instrument would be offset by a gain in the futures market when the holder buys back (offsets his short position) at an anticipated lower price. Financial institutions that own fixedincome securities or create them for sale to investors could use a short hedge to protect themselves against a rise in interest rates. For example, mortgage bankers holding a pool of mortgages for later resale to permanent investors would be vulnerable to losses on their holdings during periods of rising interest rates. By initiating a short hedge, a mortgage banker could protect himself against the price consequences of rising interest rates. The second objective-to lock in the interest cost of debt to be issued at a future time-also would entail the initiation of a short hedge in the futures market. A short hedge thus could be used by a bank in its asset/liability management. Banks especially of accounts. Parties to a forward contract are vulnerable to changes in the level of must, therefore, assess the credit worthiness of the other party to the transaction. For this reason, forward contracts may entail a greater risk of default.