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Bond Forwards and Futures

A bond forward or bond futures contract is an agreement whereby the short position agrees to deliver pre-specified bonds to the long at a set price and within a certain time window.

The forward contract is an agreement between two counterparties to exchange bonds at an agreed price and time in the future.

The futures contract is typically traded on an exchange and the underlying bond is "standardized". "Standardized" means that it is a fictional bond. The real bonds that can be delivered into the contract are translated into units of the standardized bond through a system of price factors (conversion factors) calculated according to rules determined by the exchange. The individual exchange publishes the criteria determining which bonds can be delivered, as well as the official list of bonds meeting these criteria and their conversion factors.

As with other futures contracts, the futures price is set in such a way that no cash changes hands when a contract is entered into. The payments associated with the contract occur as daily price movements are reflected in cash flows into or out of the margin accounts of the contract parties.

Bond futures are often very liquid instruments, which gives the user the certainty that he can establish and unwind positions easily and cheaply. The contract is used for hedging, speculation, and arbitrage.

The hedger can protect himself against movements in the cash market for government bonds by taking an opposite position in the futures market. This is often the most effective way of hedging exposure to movements in the medium or long interest rates in a particular country.

The speculator can trade his view on the bond cash market, as well as the relationship between long and short rates through basis trades that depend on the short term financing rate as well as on the long rates driving bond prices.

The arbitrageur exploits inefficiencies in the relationship between the futures and cash markets by establishing simultaneous positions in both futures contracts and deliverable bonds. For both the speculator and the arbitrageur, the job is made more difficult (and potentially more profitable) by the short side's right to choose which bonds on the list to deliver and when to deliver them within the allowed period.

The FINCAD solutions calculate bond forwards and futures. To evaluate the latest FINCAD solutions, contact a FINCAD Representative

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