As discussed in the introduction, interest rates have become quite volatile in the modern era. Changes may occur either because of policy action by the central bank or because of changes in the money market triggered by macro-economic changes in the domestic market, or even because of fluctuations in the foreign exchange market. Whatever the cause, institutions and individuals who borrow or lend significant sums, especially those who borrow or lend at floating interest rates, are exposed to risks arising from fluctuations in interest rates. Interest rate futures are an instrument allowing hedging and speculation in these risks. Interest rate futures are a sub-set of interest rate derivatives.

Interest rate futures or debt instrument futures

Strictly, interest rate futures are not futures contracts on interest rates per se, but rather futures contracts on underlying interest-bearing debt instruments like corporate, government and other bonds or short term deposits with a pre-specified face value and coupon (i.e., interest rate). When the maturity value of a bond or deposit is known, the implicit rate of interest (yield) can be calculated.

The underlying can be either a short term debt instrument (like a bank deposit) or a long term debt instrument (like a bond or debenture). Therefore, a futures contract on a debt instrument is ipso facto a futures contract on interest rates, but the relationship is inverse. This is different from stock or commodity futures: when one talks about these terms, one knows that one is substantially and directly dealing with the price movement in the stock and/or commodity itself, and not some implicit number therein.

The price in its own domestic market of a sovereign (i.e., central or federal) government security denominated in local currency varies exclusively and inversely on the basis of interest rates because credit and liquidity risks are nil. The coupon rate of interest on a bond reflects the rate of interest prevailing at the time the bond was initially issued, but interest rates change over time.