Future contracts for interest rates are also known as financial futures.
Future contract is standardized contract for buying or selling at agreed interest rate for duration of the contract. Future contacts are traded in future market.
Due to standardization of contracts, it is not possible to buy or sell contracts equal to capital to be invested or borrowed in future. It is also not possible to match the agreement date and settlement date of future contract with planning date and investment/borrowing date.
Buying future contract gives right to receive interest income and selling future contract imposes obligation to pay interest expense.
For borrowing (obligation to pay interest expense) in future, at agreement date, organization should enter into contract to buy (right to receive interest income) future contract at settlement date.
For investment (right to receive interest income) in future, at agreement date, organization should enter into contract to sell (obligation to pay interest expense) future contract at settlement date.
This is consistent with the primary rule of Hedging, as increase in interest expense will be offset by the increase in interest income. Similarly, decrease in interest expense will be offset by the decrease in interest income. Therefore, no gain/ no loss will result in any case.
Future contract is a Hedging product. Future interest rate depends on the expectation of interest rate movement in the physical delivery market (settlement on gross basis).
In future market, future contracts are always settled on net basis.
Future contract usually requires no or little payment in advance.
Hence, future contract is derivative product as it meets all the three conditions of derivatives.
For interest, future contract uses same terminology as used for currency futures.
