Money Market Futures - Meaning and Types

The money market is a full-fledged financial market. Hence, there are many investors who are keen to hedge the risks which emanate from the money market. The need to hedge these risks has led to the creation of several money market derivatives.

We have already studied about forward rate agreements in the previous article. However, it is important to note that the forward rate agreement is sold over the counter.

There are certain exchange-traded derivatives that are a part of the money market in various parts of the world. In this article, we will have a closer look at some of the commonly traded money market futures derivatives.

What are Money Market Futures?

Money market futures are a financial instrument that allows investors to hedge their exposure to interest rate movements in the short term. It is essentially a contract between two parties wherein one agrees to purchase a security at a given date in the future at a price that is immediately agreed upon. The other party is obligated to sell the securities at the agreed-upon price on the date mentioned in the contract.

The underlying securities usually consist of treasury bills. Since treasury bills are largely impacted by interest rate movements in the near future, this transaction essentially turns into a bet made on the direction of future interest rate movements.

Money market futures are different from forward rate agreements in the sense that there is a central body involved. This central body is known as the clearinghouse.

The clearinghouse is the counterparty to all buyers and sellers. The clearinghouse is generally an exchange. The clearinghouse not only works as a counterparty but also keeps a track of all transactions which take place. It also undertakes the backend activity required for the settlement of the contract.

The clearinghouse also undertakes risk management activity by managing the margins on behalf of the traders. The existence of a central counterparty distinguishes the money market futures from forward rate agreements and also provides more liquidity to investors.

It is also important to note that since the contracts are traded on an exchange, these contracts are standardized. The fact that these contracts are standardized makes it easy for investors to decide whether or not they want to invest since all the terms of the contract do not have to be negotiated every time a new contract is being put into place.

Commonly Traded Money Market Future Contracts

There are several types of money market futures contracts that are traded on different exchanges across the world. However, there are three types of money market contracts that are commonly traded. The details of these contracts have been listed below:

1. Treasury Bill Futures: The 13-week treasury bill futures are amongst the most commonly traded money market future contracts in the world. This contract requires the buyer to accept treasury bills with a face value of $1 million at a predetermined price.

   At the end of the contract, sellers are required to deliver Treasury securities which have only 13 weeks left to maturity. They could either deliver newly issued treasury bills that have 13 weeks maturity or they could deliver older securities that have 13 weeks left to maturity.

2. Three Month Eurodollar Deposits: The three month Eurodollar deposits are a contract where it is assumed that a notional deposit of $1 million has changed hands. One party offers a fixed interest rate on this notional principal whereas the other party offers the market interest rate. At the end of the contract, the difference between the two interest rates is compared and payment is made in order to settle the contract.

   One of the defining features of the three-month Eurodollar contract is that it is traded on multiple exchanges around the world. These contracts are homogenous and hence can be purchased in Chicago while an offsetting position can be simultaneously opened in London or Tokyo.

3. One Month LIBOR: The one-month LIBOR contract is quite similar to the three-month Eurodollar deposit. Here too, a notional sum is assumed and one party pays a fixed interest rate whereas the other pays a floating interest rate. This floating interest rate is usually the LIBOR. The main difference is that this contract is short-term in nature and hence is settled within the 30 day period.

   Just like the three-month Eurodollar deposits, these standardized contracts also trade on multiple exchanges. Hence, positions can be simultaneously opened or closed in different parts of the world.

It is important to note that there is an inherent relationship between the spot interest rates as well as the interest rates which are being quoted in these future contracts. Traders often use the quoted rates to make an educated guess about where the short-term interest rates will be.

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