Eurodollar futures prices are listed for 40 quarterly contracts. The largest trading volume exists for the first two dozen futures contracts, after which both volume and open interest diminish significantly for the remaining 16.
Despite low volume in further out contracts, the price curve is relatively smooth (see “The normal pattern,” below). Variations from the price curve above a few basis points are a rare occurrence for any individual contract.
The reason for this consistency in pricing is that Eurodollar futures rates are tied fundamentally to the U.S. Treasury yield curve, and the underlying yields normally form a curve in which yield changes between sequential maturities are small. Eurodollar market rates, Treasury yields and computed Eurodollar yields are combined on “Yields and rates” (below) covering the 40-quarter span of Eurodollar data up to Nov. 28, 2005.
BREAK FROM NORMALITY
Occasionally, events in the money market create a situation in which the Treasury yield curve differs from its normal shape. When this happens, rates and prices of Eurodollar futures also are forced out of their normal patterns. For example, the price curves for Eurodollar futures observed on different dates would normally converge at or near the same point and would show a fairly consistent curve from that point down toward longer maturities.
On “The normal pattern” the highest points on several price curves correspond with the lowest near-term yield of Treasury securities, and as Treasury yields increase along with T-bond and T-note maturities, declining Eurodollar futures prices reflect the increasing yields.
As long as Eurodollar price curves like those for February and March were expected, a hedger in this market might have taken a long position in a short-term contract and a short position in a slightly longer-term contract planning to profit from the steeper slope of short-term prices.
It is obvious the Eurodollar hedging strategy depends on the stability of the price curves, not to remain at the same level but to maintain the relationships between various maturities. The primary risk in the hedging strategy is that the shape of the curve may change.
TREASURIES LEAD THE WAY
The main cause for a change in the shape of the Eurodollar price curve is a shift in the underlying U.S. Treasury yield curve. When the Treasury curve became flat during the fall months of 2005, Eurodollar rates responded (see “Increasing waves,” below). This shows the beginning of a change on Sept. 30, with an increasingly sharp slump in short-term prices to Nov. 30.
Changes in pricing relationships as the wave develops suggests new trading strategies and show the risk inherent in the original hedge position. Because the wave formation created by Eurodollar prices in October and November is caused by an abnormal Treasury yield curve, it might be predicted that prices such as the June and September 2006 contracts will return to a normal level with respect to March and June 2007. This would mean, as long as the wave is present, taking long positions in the 2006 futures and shorting 2007 contracts, hedging against changes in the level of yields and rates while depending on changes in the wave to provide a hedged gain.
A brief simulation analysis shows why Eurodollar rates and prices respond predictably to changes in the shape of the Treasury yield curve.
Because of the underlying mathematical relationships, there actually is no choice on the part of Eurodollar rates as to the type of rate and price curves that are formed in response to Treasury yield movements. The simulations are accomplished by using the “From Fed to Market” calculations shown in “Trading Interest Rate Inefficiencies,” January 2006. We back up from a hypothetical Treasury yield curve to a Eurodollar futures yield curve by adding a constant TED Spread, then we compute the Eurodollar rates that formed the yield curve.
The first simulation, “The disappearing wave,” (below) shows Treasury bond and note yields rising with increased maturities along a smooth upward sloping curve with no initial sharp increase and no flattening with longer maturities. Note that the matching simulated Eurodollar rates also rise at a gradual rate with no indication of the wave that existed during the fall and winter of 2005.
When simulated Treasury yields are changed so that short-term yields start at a low point, then increase sharply to a series of flat yields, the response by Eurodollar rates is to increase even more sharply in the short-term (see “Wave forms to the left,” below) This forms a hump in rates before declining to the smoother long-term upslope.
As shown on the second simulation chart, this appears to be the cause of the wave formation in Eurodollar futures prices. The temporary nature of the wave is related to the timing of the unusual formation of Treasury yields.
Behind changes in Treasury yields are shifts in Federal Reserve policy actions. For example, the flat yield curve resulted from the Fed continuously increasing short-term rates, generally by a quarter percent each time, through a period of more than one year. The purpose was to contain inflation; however, the capital and money markets did not respond with increased rates. This left long-term yields approximately equal to short-term yields, hence the pattern that caused the Eurodollar price wave.
TO TRADE OR NOT TO...
Is it appropriate to use the wave formation as the base for trading Eurodollar futures? It is possible that there are three times when the wave should assist trading decisions.
First, before a wave develops it may be possible to forecast the changing shape of Eurodollar prices by observing Treasury yields. When the Treasury yield curve becomes progressively flatter, it may be implied a Eurodollar price wave will follow. This is the time to reduce the risk of hedging along a price curve that slopes up toward shorter maturities and to be prepared for lower prices of near-term maturities.
Second, after a wave is formed, hedged positions must take into account the possibility of increasing depth of price declines. When it seems the bottom of the wave has been reached, and possibly that Federal Reserve policy is allowing the Treasury yield curve to return to normal, it is time once again to go long in the second, third and fourth quarterly contracts and hedge by taking short positions in the sixth and seventh quarters.
Third, as the wave disappears and Eurodollar prices return to the normal downslope from the nearest maturity, the original type of hedging, depending on a gradual increase in prices to the near-term maturities, may be resumed.
Because changes in the shape of the Treasury yield curve similar to those that occurred in the last months of 2005 are relatively rare, it may be some time before another Eurodollar price wave forms. This is the time to reduce the risk of hedging along a price curve that slopes up to the left and to be prepared for lower prices of near-term maturities.
Even if the price wave that existed at year-end 2005 does not continue for long in 2006, knowledge of the wave itself and the causes of its formation and ultimate dissolution should be useful information for future trading. As always, the best advice for participants in the Eurodollar futures market is to keep an eye on Federal Reserve actions and other factors leading to changes in the U.S. Treasury yield curve.