A Primer on Futures and Kessler
De-mystifying an under-utilized tool to take on UST fixed-income exposure, long or short.
Futures in general
Futures contracts arose to fill a need for those that wanted to buy, sell, or hedge against things
that are physically hard to move from one place to another; things big and heavy; things like
corn, oil, gold, or lumber. Futures contracts provide a way to trade these things by setting a
price now but then arranging the settlement date (day to exchange money for the goods) way
out into the future (usually 3 or more months away). This long separation between trade and
settlement date (‘delivery’ in futures parlance) facilitates trading without the immediate concern
of having to move it to buyer from seller. The standard definition of a futures contract obscures the real reason for their popularity. The
definition of a futures contract from Investopedia (my emphasis), “A contractual agreement, generally made on the trading floor of a futures exchange, to
buy or sell a particular commodity or financial instrument at a pre-determined price in
the future. Futures contracts detail the quality and quantity of the underlying asset; they
are standardized to facilitate trading on a futures exchange. Some futures contracts
may call for physical delivery of the asset, while others are settled in cash” This definition eschews trader motives in favor of academic correctness which really doesn’t
help anyone. It seems to imply that a trader has a specific interest in this future date and an
opinion about what will happen to the price in-between now and that date. In practice, both of
these are largely irrelevant. The ‘pre-determined price’ is simply where that contract is trading
which effectively tracks where the ‘spot’ or current price is. The date in the future is chosen
with regularity (i.e. each quarter) and is only important to the extent that it is far away. The most
important thing to first understand about futures is that they track the price of the underlying
instrument without having to physically exchange it back and forth for a long time into the
future.
The concept of a period of time in-between the trade date (date when price is set) and the
settlement date is not unique to futures. Stocks, for instance, trade on a ‘t+3’ schedule,
meaning that settlement happens three trading days after the price is set. Treasuries trade as
‘t+1’, meaning that they settle one day after the day the price is set. Futures, in this context,
can be considered to be ordinary trades but with ‘t+90’ or ‘t+x’, where x is the number of
trading days from now until the futures contract settles (delivery). The next step, financial futures
With futures, because you can both open and close your position before it gets to settlement,
their concept applies well to financial instruments because they provide a way to own more
than you have capital for: implied leverage. Consider this example with a fictional stock to see implied leverage. Say a trader was to buy 10
shares of a stock at $100, but then by a market movement was also able to sell the 10 shares
later that day at $105. In three days, these two trades will settle together. On settlement date,
the buy of 10 would be a debit to the account for $1,000 (10 x $100), and the sale of 10 would
be a credit of $1,050 (10 x $105). These two would offset against each other and just the gain
of $50 is posted to the trader’s account. Without regulations, the trader wouldn’t have needed
the full $1000 in their account to make and settle this trade. In fact, there was nothing to
prevent the trader from doing this trade with 100, 1000, or 1million shares, without having the
money to outright pay for them. The trader was only at risk for the price change of the stock. Of
course, in real life, because the possibility of losing is just as large as gaining, government
regulations and dealer practices prevent or diminish the ability to buy and sell more than you
could reasonably pay for in the stock market. The point of this example is to show that because the settlement dates for two trades (buy and
sell) occur on the same date and because the position netted to nothing (10-10=0), leverage
(owning more than you have capital for) is possible. Futures contracts have just carefully
formalized this relationship. Nearly all futures traders will close their futures positions before
they get to settlement/delivery to take advantage of not needing to have or borrow the full
amount that the contract is worth.
With a futures contract, rather than owning the instrument itself, you effectively own just the
‘price change’ of the instrument. So, as a replacement for the requirement to have all the funds
required for a trade (the $1000 in the prior example) in traditional financial markets (stocks and
bonds), the futures exchange requires that an account hold just a small fraction of that value;
margin to cover what gains and losses might be. The margin amount is chosen by the
exchange and fluctuates over time based on how volatile the price of that contract has been
recently. More volatility requires more margin. Some examples of financial futures contracts are
in the table below (as found on 9/02/2014).
Contract
S&P 500
USD/EUR currency
30yr UST Bonds
15yr UST Bonds
10yr UST Bonds
5yr UST Bonds
2yr UST Bonds
Column identifier
Formula
Contract
Value (price x
Margin required
contract size)
(chosen by
exchange)
$499,875
$164,113
$153,688
$138,906
$125,313
$118,563
$218,906
$25,300
$1,925
$3,190
$2,310
$1,430
$990
$302.50
a
b
Implied
Leverage
19.8 to 1
85.3 to 1
48.2 to 1
60.1 to 1
87.6 to 1
119.8 to 1
724 to 1
Margin/contract
value
5.1%
1.2%
2.1%
1.7%
1.1%
0.8%
0.1%
c
= a/b
d
= 1/c
In the table, you will notice that the ‘margin/contract value’ covers a large range. This is a
reflection of the wide range of differing volatilities in different markets. Because leverage
amount * instrument volatility = portfolio volatility, it follows that by combining multiples of lesser
volatility contracts, one can assume higher volatilities in their portfolio. For instance, it would
take about 2.5x as many 30yr bond futures to have similar volatility as with the S&P 500 using
the figures in the table (5.1%/2.1%=2.43).
With control over leverage, futures allow the easy application of ‘risk parity’ to a portfolio. The
concept of ‘risk parity’ was developed to address the phenomenon that the fixed-income side
of a portfolio often has much less volatility than the stock market side of a portfolio, and that
portfolios don’t necessarily benefit from or even want this. If an investor is comfortable with the
volatility of the stock market (for example), there is really no reason not to assume this same
degree of risk in the bond market, with the benefit of raising long-term bond returns to a level
competitive with or often exceeding the stock market.
At Kessler, we think more about how different places on the UST yield curve have differing
amounts of volatility. In the table before, notice how as the length to maturity shortens (30yr,
10yr, 5yr, etc.), that the margin required also successively diminishes. This is mostly because
of duration; the bond’s price sensitivity to movement in interest rates. Shorter maturities
naturally have less duration. We construct portfolios in terms of ‘duration parity’ to fully
separate the concept of yield curve positioning from price sensitivity. Without control over
leverage, when a management decision to change exposure to a different place on the yield
curve (say, go from the 10yr UST to the 2yr UST), a large change in the interest rate sensitivity
(much lower in the example) comes with it. Not so for Kessler. Having control over leverage
allows us to isolate decisions on the yield curve from decisions on duration. For example, when
the Fed is lowering rates, it is often far more advantageous to be long 4 to 1 2yrs rather than 1
to 1 10yr UST, even though the two portfolios have roughly the same amount price sensitivity.
Also, despite high levels of leverage being available in the futures market, there is nothing to
prevent a portfolio to own futures with 1 to 1 leverage. A single 10yr UST future contract with
the full amount of cash of the contract’s value in the account ($125,313 from the table above)
will mimic the performance (with no disadvantage) of that amount invested into an actual 10yr
UST. Futures highlight an important concept crucial to understanding financial markets. One-to-one
leverage or owning a security for cash, is often thought to be endemic to investing, but it is not
necessarily the best way to own financial instruments. The futures market encourages investors
to free ‘leverage’ from a fixed ‘1’ (owned for cash) into a choice (both above and below 1) to
control the volatility of different securities and asset classes. Futures Carry
All futures include, by traders’ economic motives, what one would earn or pay if instead of
holding the futures contract, they held the underlying instead; often called the ‘carry’. The
physical asset (underlying) and futures contract orient themselves (by market forces) to be
economically identical, otherwise free money would be available to someone (arbitrage). With
the original agricultural and metal (big and heavy) futures, the futures reflect the storage fees
associated with those things. With S&P 500 futures, they reflect the dividend yield minus the
cost of financing. With currencies, they reflect the short-term interest-rate differential between
the two currencies, and with bonds, they reflect the coupon minus the cost of financing. In
other words, the total return of holding a futures contract mirrors the total return of holding the
physical asset. Advantages and Disadvantages of Futures
With futures, there are advantages that the cash markets do not have. 
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Economies of scale: the best financing rates are built-in to the contracts. Treasuries
finance always near-to the Fed Funds overnight rate, the cheapest financing in the
financial complex. Exchange trading o More trading hours, limit orders, electronic trading o Because of the standardization of UST futures across yield curve ranges, there
is enough volume to support options markets that are not viable on individual US
Treasury issues. o Transparent pricing, all trades are made public through the exchange. o Counterparty risk is spread amongst the entire body of futures participants o Daily mark-to-market clearing which eliminates the build-up of credit risk (the
main reason why ‘derivatives’ get a bad name.) Leverage without borrowing
Accounting simplification: in Treasury bond futures 3 different economic streams
(coupon, financing, and price) are collapsed into one price. Being short is as natural as being long: Being short in the cash Treasury market
requires borrowing specific issues, with futures, there are as many shorts as longs (a
short and a long together create each contract), and no borrowing of collateral is
necessary.
US Taxation (60% long-term capital gains no matter what): For US taxable entities,
taxes are calculated each year on realized and unrealized gains or losses (change in
account’s net liquidation value). This clears the tax liability each year in sync with total
account value change. In exchange for this yearly burden, the IRS grants 60% of all
gains to be considered long-term capital gains/40% to be short-term.
Disadvantages
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No ability to buy specific UST issues that may be mis-priced or financing cheaper
(special). Futures cannot be held to maturity like the underlying, they must be rolled
quarterly to retain exposure.
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Diminished granularity: Treasury bonds can be bought in increments of 1,000 face
value. Treasury futures can only be bought in increments of 100,000 face value
(200,000 for 2yr UST futures). Reduced ability for precise yield curve targeting: For example ,due to the delivery
bond of the 10yr UST futures being close to the 7yr UST, exposure at the 10yr point on
the yield curve cannot be had using futures. Kessler and Interest rate futures
Kessler pioneered the portfolio ownership of US Treasuries with leverage in the late 1980’s.
Coupons higher than the cost to finance them could be multiplied to create portfolios with
tremendous yields, but also with attendant higher price volatility. These portfolios can be wellreplicated in the futures markets and accrue the same positive carry advantage of the
portfolios structured with actual US Treasuries. This is well suited to accounts not large enough
to have repo financing accounts.
Eric Hickman
President
Kessler Investment Advisors, Inc.
9/2/2014
Please note: Several generalizations have been made in this piece in order to make the
concepts more accessible. Trading futures and options involves the risk of loss. Please
consider carefully whether futures or options are appropriate to your financial situation. Only
risk capital should be used when trading futures or options. Investors could lose more than
their initial investment. Past results are not necessarily indicative of future results. The risk of
loss in trading can be substantial, carefully consider the inherent risks of such an investment in
light of your financial condition.