Solving the Mystery of Treasury Futures’ Pricing

Don Dawson

Trading Futures requires one to understand something, when we (the speculators) are in the Futures markets trading we are actually just a guest. The hosts are the Commercial traders whom the Futures markets were originally created for. The Futures Exchange that the products trade on is simply an intermediary providing a central location for buyers and sellers to come together and make their transactions.

Free WorkshopCommercial traders make up, on average, 60% of the Open Interest (positions that have not yet been offset) in the Futures industry. They are in the market simply to manage price risk and not to speculate. Their style of trading is usually around something called basis (difference between the cash price of the Commodity and the Futures contract on that same Commodity). We speculators provide the liquidity for these Commercials to offset their price risk. When they want to sell and hedge price risk to the downside, we are the ones they buy from. When they want to buy and lock in low prices for future delivery, we are the ones that they sell to.

Since we are a guest we must remember to act like one and not complain about trading the same Futures contract (a standardized contract that all market participants must trade) that the Commercials are trading. Inside this contract has well defined specifications and among these is one called minimum tick (smallest amount the price can change per trade) and the dollar value of this minimum tick.

Because they trade in 32nd’s, the Treasury markets have probably one of the more complex tick increment and dollar values to grasp for a new Futures trader. While the Stock market went away from fractions many years ago, the Treasury Futures market has kept them.

The reason we still trade in 32nds is the same reason Natural Gas prices trade in a price format of 0.001. The reason is that, when a Commercial places a hedge in the market using a Futures contract it needs to be priced in the same format that they deal with the product in the cash market. This allows an “apples to apples” hedge when both products are priced in the same format. In the Stock market everything trades in .01 format no matter what the Stock is. This is why a Futures trader must learn about the unique contract specifications of each Futures market they are going to trade.

A Commercial using the Bond market to hedge might be somebody like an institution/dealer that buys Treasuries at the auctions the Government has on a regular schedule. Bonds that are sold at auctions are priced in 32nds and, therefore, the Futures contract also trades in 32nds to allow for proper hedging. Once the institution/dealer buys these Bonds at the auction they will hold them in inventory until their sales team can sell them. In the meantime, if interest rates change the institution/dealer could lose money on their initial Bond auction purchase.

Websites like Bloomberg.com have daily tables showing what the cash Treasury prices are, while we traders are normally looking at the Futures prices. Futures prices are currently trading much higher than the cash Bond prices.

Let’s look at how a cash Bond’s dollar price is derived.

The Bond’s dollar price represents a percentage of the Bond’s principal balance, also known as par value. Remember that a Treasury Bond is simply a loan the U.S. Government is making with you (the lender) and the principal balance (par value) is the loan amount. Depending on when you buy the Bond from the Government and the interest rate at that time, you will find price quotes of perhaps 99-23 as an example. And if you were buying a $100,000 (par value) 30 year Treasury Bond you would pay $99,718.75.

Now let’s walk through the math for the purchase of this cash Bond from the U.S. Government. Much like our Futures contracts, the cash price has a full point value (handle) and ticks made up of 32nds . The 30 year cash Treasury Bond has a handle of “99”, the “23” represents the 32nds or ticks. To get to our purchase price we must convert these values into a percentage to determine the dollar amount.

Taking the ticks first we divide 23 by 32. This will equal .71875. Next we add this amount back to the handle of 99. And we will get 99.71875. Meaning 99-23 equals 99.71875% of the par value of $100,000, which equals $99,718.75.

In this example the 30 year cash Treasury Bond is trading at a discount which means that it is trading at less than par value. Had the price been trading at par the price would have been $100,000. And, if the price had been at a premium, the Bond price would have been greater than $100,000.

Obviously there is more to discuss about premiums and discounts but, simply put, an investor would pay more than the par value to get a Bond with a higher yielding coupon value (higher interest income from the Bond) that was issued when interest rates were higher. This higher interest rate income helps offset the higher priced Bond above par value.

This was just an example of the cash Treasury Bond markets and why the Treasury Futures contracts must trade in 32nds and portions thereof. All Futures contracts are specified and standardized so that speculators and Commercials alike know all the terms going into the contractual agreement. It is, therefore, up to the individual speculator to become familiar with their respective markets they wish to trade.

“Every job is a self-portrait of the person who did it. Autograph your work with excellence.”

Don Dawson

This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.