In the most basic terms, a derivative financial product has a value based on another financial product. A Treasury derivative would use some form of U.S. Treasury security — bills, notes or bonds — as the base or underlying asset. Derivatives allow financial firms and traders to use portfolio strategies based on the prices and rates in the Treasury market.
The Treasury Market
The U.S. Treasury securities market is the largest and most liquid of the various bond markets. With over $600 billion of Treasury securities traded each day, the market provides a very visible source of bond prices and yields. Investors view Treasury debt as free of default risk. These features combine to make the Treasury market the benchmark for short- and long-term interest rates. The rates and prices of other income investments can be based on or compared with the appropriate Treasury security. The size and significance of the Treasury market facilitate the use of Treasury securities as the base instruments for financial derivatives.
Uses of Derivatives
Derivatives serve one of two basic functions. A derivative hedge protects against an adverse outcome. For example, rising interest rates will cause bond prices to decline. A Treasury derivative used as a hedge would rise in value to offset a decline in Treasury security prices. Derivatives can also be used to speculate on changing prices. Treasury derivative products are traded to make leveraged bets on potential changes in interest rates or Treasury prices.
Treasury derivative products listed on established exchanges can be bought, sold and traded by both individuals and financial firms. The two major types of Treasury derivative products are futures and options contracts. Treasury futures trade on the commodity futures exchanges, and a futures contract allows the control of a large amount of a specified Treasury security with a small margin deposit. Options contracts provide the option to buy or sell the underlying asset. Options on Treasury securities include options on Treasury futures and options trading against Treasury bond exchange-traded funds, or ETFs.
Financial firms, hedge funds and investment management companies often use private Treasury derivative products. These two-party derivatives do not trade on the open markets. Types of private Treasury derivatives include interest rate swaps, forward contracts, rate floors and caps and private options. As an individual investor, you cannot trade these types of derivative products. However, you may see that a company in which you invest uses these products to protect against changing interest rates.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.