The Basics of US Treasury Futures

INTRODUCTION

CBOT Treasury futures are standardized contracts for the purchase and sale of US government notes or bonds for future delivery. The US government bond market offers the greatest liquidity, security (in terms of credit worthiness), and diversity among the government bond markets across the globe. The US government borrows through the US bond market to finance its maturing debt and its expenditures. As of October 2016, there were $19.8 trillion of US government bonds and notes outstanding as marketable debt.

The US government borrows money primarily by issuing bonds and notes for a fixed term, e.g. 2-year, 5-year, 10-year, and 30-year terms at fixed interest rates determined by the prevailing interest rates in the marketplace at the time of issuance of the bonds. Strictly speaking, US Treasury bonds have original maturities of greater than 10 years at time of issuance, and US Treasury notes have maturities ranging from 2-Yrs to 10Yrs (2, 3, 5, 7 and 10yr). For the purpose of this note, US Treasury bonds and notes are applicable for general references to the US bond market or US bonds unless described otherwise.

US Treasury bonds trade around the clock leading to constant price fluctuations. In general, bond prices move in inverse proportion to interest rates or yields. In a rising rate environment, bondholders will witness their principal value erode; in a declining rate environment, the market value of their bonds will increase.

IF Yields Rise ▲ THEN Prices Fall ▼
IF Yields Fall ▼ THEN Prices Rise ▲

The US Treasury futures and options contracts are available for each of the Treasury benchmark tenors: 2-year, 5-year, 10-year, and 30-year. The Ultra 10-Year futures contract provides hedging and spreading opportunities at the 10-Year point of the Treasury yield curve, and has been the fastest growing Interest Rate futures contract at CME Group since it was launched in January 2016.

Each of the bond and note future contracts has an associated delivery bond basket that defines the range of bonds by maturity that can be delivered by the seller to the buyer in the delivery month. For example, the 5-year contract delivers into any US government fixed coupon bond that has a remaining maturity of longer than 4 years and 2 months and an original maturity of no more than 5 years and 3 months. The delivery mechanism ensures the integrity of futures prices by ensuring that they are very closely tied to the prices of US government bonds and their yields (interest rates). In practice, most participants trade US Treasury futures contracts with the intent of either closing out the futures position or rolling them into longer expiry futures contracts. The US Treasury futures are listed on the March, June, September, and December quarterly cycles. Since 2000, only about 7% of Treasury futures positions result in physical delivery at expiration.

Table 1: CBOT Treasury Futures Contract Details

  2-Year T-Note Futures 5-Year T-Note Futures 10-Year T-Note Futures Ultra 10 Futures T- Bond Futures Ultra T-Bond Futures
Face Amount $200,000 $100,000 $100,000 $100,000 $100,000 $100,000
Deliverable Maturities 1 3/4 to 2 years 4 1/6 to 5 1/4 years 6 1/2 to 10 years 9 5/12 to 10 Years 15 years up to 25 years 25 years to 30 years
Contract Months March quarterly cycle: March, June, September, and December
Trading Hours Open Auction: 7:20 am - 2:00 pm, Monday - Friday; Electronic: 5:00 pm - 4:00 pm, Sunday - Friday (Central Times)
Last Trading & Delivery Day Last business day of contract month; delivery may occur on any day of contract month up to and including last business day of month Day prior to last seven (7) business days of contract month; delivery may occur on any day of contract month up to and including last business day of month
Minimum Tick In percent of par to one-quarter of 1/32nd of 1% of par In percent of par to one quarter of 1/32nd of 1% of par In percent of par to one-half of 1/32nd of 1% of par In percent of par to one-half of 1/32nd of 1% of par In percent of par to 1/32nd of 1% of par In percent of par to 1/32nd of 1% of par
Minimum Tick Value $15.625 $7.8125 $15.625 $15.625 $31.25 $31.25

For complete information, visit http://www.cmegroup.com/trading/interest-rates/

Each US Treasury futures contract has a face value at maturity of $100,000 with the exceptions of 2-year and 3-year US Treasury futures contracts which have face value at maturity of $200,000. Prices are quoted in points per $2000 for the 2-year and 3-year contract and points per $1000 for the all other US Treasury futures. The fractional points are expressed in 1/32nd in line with the convention in US government bond market. The minimum tick size for the 30-year (T-Bond) and Ultra T-Bond contracts is 1/32nd of one point ($31.25), 10-Year and Ultra 10-Year is half of 1/32nd of one point ($15.625), and 2-year, 3-year ($15.625) and 5-year contracts are one-quarter of 1/32nd of one point ($7.8125).

Treasury futures are standardized, highly liquid, and transparent instruments. In 2016, CME US Treasury Futures traded an average of 3.38 million contracts daily. In addition, futures are a neutral security, which can be easily traded from the long or short sides. Treasury futures positions provide the security of facing CME Clearing, which acts as the counterparty to every trade*. Finally, US Treasury futures provide easy access to leverage and both capital and operational efficiencies. These are among the reasons US Treasury futures have a broad and diverse mix of customer types including Asset Managers, Banks, Corporate Treasurers, Hedge Funds, Insurance Companies, Mortgage Bankers, Pension Funds, Primary Dealers, & Proprietary Traders. The vast hedging and speculative activity in US Treasury futures create nearly constant price fluctuations providing excellent opportunities trading for individual traders in addition to institutional trading accounts.

Trading Examples – US Treasury futures:

Historically, when the economy strengthens, interest rates are likely to rise for a number of reasons such as:

  • increased demand for loans
  • asset allocation out of bonds (typically considered a safe asset class) into stocks (typically considered a risky asset class)
  • increased likelihood of interest rate increases by the Federal Reserve Board

When interest rates rise, US Treasury futures prices fall.

Similarly, when the economy weakens, interest rates are likely to fall for reasons such as:

  • decreased demand for loans
  • asset allocation out of stocks into bonds
  • increased likelihood of interest rate cuts by the Federal Reserve Board

The US economy is more like a cruise liner than a speed boat in that it often stays on a path of strengthening or weakening for several months to a few years. This causes broader moves in interest rates that are spread over considerable time periods as opposed to very short periods. Nevertheless, US Treasury futures produce short term trading opportunities, as demonstrated in the following examples.

Example 1: A trader believes that the US economy is strengthening and intermediate Treasury yields will increase (5-Yr and 10-Yr).

This trader sells 10 contracts of March 2014 5-year US Treasury Note futures at 120 25/32.

The trader’s view proves correct. The economic numbers continue to show that the US economy is strengthening. 5-Yr Treasury yields rise, and the March 2014 5-year T-Note futures price declines. The trader buys back the 10 March 2014 5-year T-Note futures contracts at 120 03/32.

Profit on this example trade = 10 * (120 25/32 – 120 03/32) * $1000 = $6,875

(Profit or Loss = Number of contracts* Change in price * $1000)

The profit calculation in this example can also be expressed in terms of minimum ticks or simply referred to as ticks. The tick size for 5-year contract is ¼ of 1/32nd of 1 point.

The $ value for minimum tic of the 5-year contract is $7.8125.

Number of ticks made on the trade = (25/32 – 3/32) * 4 = 88 Ticks

Profit on this example trade = 10 Contracts X 88 Ticks X $7.8125 = $6875

Example 2: The monthly US non-farm payroll number on the first Friday of a month comes out significantly weaker than expected. This indicates a surprisingly weakening economy. As a result,

Treasury yields decline, and US Treasury futures prices rise. A trader notices that the March 2014

10-year T-Note futures have responded to the report by posting modest rally from 125 05/32 to only 125 15/32. He believes that the weakness in the number was a significant surprise and more participants will soon need to buy notes.

This trader buys 10 contracts of March 2014 10-year T-Note futures at 125 15.5/32.

The trader view proves correct. Intermediate Treasury yields continue to fall, and the

10-year T-Note future price rises further. An hour later the trader sells back the 10

March 2014 10-Yr T-Note futures contracts at 125 23/32.

Profit on this example trade = 10 * (125 23/32 – 125 15.5/32) * $1000 = $2344 (rounded to nearest dollar)

Similar to the previous example, let us recalculate the profit in this example using ticks. The tick size for 10-year contract is 1/2 of 1/32nd of 1 point. The $ value for minimum tic of the 10-year contract is $15.625.

Number of ticks made on the trade = (23/32 – 15.5/32) * 2 = 15 Ticks

Profit on this example trade = 10 Contracts X 15 Ticks X $15.625 = $2344 (rounded to nearest dollar)

CONCLUSION

The US Treasury futures complex of the CME Group consists of liquid and easy to access markets that offer a wide variety of strategies for a broad and diverse mix of customer types needing to hedge exposures to interest rates and traders seeking to assume risk to take advantage of anticipated changes in interest rates. For additional details on Treasury futures and trading strategies please refer to:

The New Treasury Market Paradigm:
cmegroup.com/treasuryparadigm

Treasury Analytics Tool:
cmegroup.com/treasuryanalytics

Pace of Roll Tool:
cmegroup.com/irpaceofroll

CFTC Commitment of Traders Tool:
cmegroup.com/cot

Invoice Swap Spread Trading:
cmgroup.com/invoicespreads

GLOSSARY:

Accrued interest – the interest that accumulates between fixed coupon payment dates.
ADV – Average Daily Volume, commonly used by CME to describe the trading activity in a contract.
Arbitrage – simultaneous trade between two markets using the same security. E.g. buying the same US T-Bond from one party while simultaneously selling it to another party at a slightly better price. This term has morphed over time and now is used when describing trading between markets with similar securities.
Basis – usually refers to the spread between a futures contract and its underlying physical or spot market.
BPV, VBP, and DV01 – all refer to the same thing, the change in dollar value of a security caused by a 0.01% change in yield.
Carry – refers to the value or cost of financing a security over time. Can be expressed in positive or negative terms.
CF – or conversion factor, refers to the CBOT Conversion Factor pricing system for US Treasury futures contracts.
Coupon Yield – interest rate of a security fixed at issuance, usually expressed in annual terms. For
example, a 2% bond pays 2% interest annually. Treasuries are quoted in coupon yield expressed in annual terms but pay interest twice per year.
CTA – Commodity Trading Advisor, designation applied to registered advisors of commodity funds.
CTD – cheapest-to-deliver, or the US Treasury security most efficient to deliver into a Treasury futures contract.
Duration – change in value of a security to a 1% change in rate, expressed in years. For example, a bond with a 5-year duration will lose 5% of its value if rates rise by 1%. Used to measure the risk of individual bonds or bond portfolios.
Eurodollar – US Dollar denominated deposits held outside the US and not under the jurisdiction of the Fed.
Face Value – a.k.a. Par Value, or par, the dollar amount to be repaid to holder of the security at maturity, e.g. A $1,000 face value, 2% 10-Year Note will pay 1% twice a year for ten years and at the last payment return the to the holder $1,000.
Fed – short for Federal Reserve, the US Central Bank.
Fed Funds – rate a which member banks may trade balances held at the US Fed.
IMM – International Monetary Market, a division of the Chicago Mercantile Exchange.
IPO – Initial Public Offering, designation when a newly listed stock hits the market for the first time. IRS – as it relates to the capital markets refers to Interest Rate Swaps.
LIBOR – London Inter-Bank Offer Rate, cash benchmark rate determined by survey of London based banks. Used extensively by the IRS market to price floating rate side of swaps.
OI – Open Interest, used by exchanges to describe open positions at the end of a daily trading session.
Repo – agreement to sell and repurchase a security in exchange for terms. The Repo market for US Treasuries provides overnight funding for banks and dealers in government securities and allows short sellers of securities to borrow securities in exchange for funds.
STIR – Short-Term Interest Rates
Swaps – a derivative in which counterparties exchange cash flows of one party’s financial instrument for those of the other party’s financial instrument.
TED – Treasury versus Eurodollar spread.
US Treasuries – or “Treasuries”, debt issued by the US Federal Government offered in multiple maturity dates auctioned on a regular auction schedule. Treasuries are made up of T-Bills, T-Notes, T-Bonds, and TIPS.
UST-Bills – Treasuries with original maturity of less than 1-year.
UST-Notes – Treasuries with original maturities of 2-years but no more than 10-years.
UST-Bonds – Treasuries with original maturities of more than 20-years.
Yield – refers to return on investment but can mean different things i.e. coupon yield, yield to maturity, current yield, and tax except yield all describe different aspects of a bond’s yield.
Yield-to-Maturity – or YTM, an estimate of what the investor will receive if the bond is held to maturity.
ZIRP – Zero Interest Rate Policy, policy of the Fed to hold Fed Funds rate at near zero percent.

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