A widely used trading and risk management instrument in the bond markets is the government bond futures contract. This is an exchange-traded standardised contract that fixes the price today at which a specified quantity and quality of a bond will be delivered at a date during the expiry month of the futures contract. Unlike short-term interest rate futures, which only require cash settlement, bond futures require the actual physical delivery of a bond when they are settled. They are in this respect more akin to commodity futures contracts, which are also (in theory) physically settled.
In this first chapter we review bond futures contracts and their use for trading and hedging purposes.
A futures contract is an agreement between two counterparties that fixes the terms of an exchange that will take place between them at some future date. They are standardised agreements as opposed to ‘over-the-counter’ or OTC ones, as they are traded on an exchange, so they are also referred to as exchange-traded futures. In the UK financial futures are traded on LIFFE, the London International Financial Futures Exchange which opened in 1982. LIFFE is the biggest financial futures exchange in Europe in terms of volume of contracts traded. There are four classes of contract traded on LIFFE: short-term interest rate contracts, long-term interest rate contracts (bond futures), currency contracts and stock index contracts.
Bond futures contracts, which ...