Hedging with Treasury bond futures is a tactic to protect the value of a portfolio of Treasury bonds from falling bond prices. If interest rates increase, the market price of long-term Treasury bonds can decline significantly. The futures on Treasury bonds can be used to protect bond holdings against such a value decline.
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Futures are standardised contracts for the future delivery of a commodity or financial instrument. Futures trade on specific exchanges; most Treasury bond futures trade on the Chicago Board of Trade or electronically through the CME Globex system. To trade futures you must establish an account with a licensed commodity futures broker. Futures contract trades are secured with a margin deposit. The exchange sets the amount of margin deposit required for each type of contract. Futures contracts can be traded to move in either direction. Contracts are bought to open a trade if the underlying asset is expected to go up or contracts are sold to open a trade to profit from falling prices.
Treasury Bond Futures
Futures on Treasury securities are available to trade against a range of Treasury bonds. Futures exist for 5- and 10-year notes, the 15- to 25-year Treasury bond and the over-25-years-to-maturity Treasury bond. Treasury futures maturities come up every three months and are available out to either 9 or 15 months in the future. One Treasury futures contract is worth £65,000 of the designated Treasury securities.
Hedging With Treasury Futures
Say an investment manager has a portfolio of £3 million in long term Treasury bonds and wants to hedge against rising interest rates. Treasury bond futures could be used to provide a hedge that will go up in value to offset any decline in the portfolio value. To hedge the bond portfolio, the investment manager would sell 50 Treasury bond futures contracts. The initial margin deposit for a Treasury bond futures contract is £2,193. The margin deposit for the 50 contracts would be £109,687.
Managing the Hedge
If interest rates rise and bond prices fall, the sold futures contracts positions will increase in value by approximately the same value lost on the bonds. If, instead of declining, bond prices go up, the futures will lose value at the same rate. The trading costs of futures is low, so if the bonds do not move in value, the Treasury futures could be closed with a buy order and the margin deposit money, less trading commissions, returned to the futures trading account and be available to support futures trades.
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