Short-term interest rate (STIR) futures and options include those traded on the CME Group and Euronext Liffe. Although the various STIR futures and options contracts have different specifications, all are subject to the same valuation methods. The consistency of pricing models between the markets should help in planning hedging, speculation and spread trades.
Eurodollar futures, based on the London Interbank Offered Rate (Libor) are traded on both the CME and Liffe. The CME lists 40 future quarterly rates, while there are 20 quarters shown by Liffe. Each quarterly eurodollar futures contract covers a $1 million deposit of U.S. dollars in a non-U.S. bank deposit. A shift of one basis point (0.01 of one percent) in the quarterly rate equals a $25 change in the value of the futures contract, which is listed as 100 less the quarterly rate.
“Yields and rates” shows eurodollar rates listed by CME at the close of trading on Aug. 28, 2008. Also shown on “Yields and rates” are the quarterly eurodollar yields, computed as a series of geometric means of quarterly rates, and U.S. Treasury yields for two-, five- and 10-year maturities, as listed by Bloomberg.com. A valuation principle expressed by this chart is that eurodollar rates are arranged in a pattern that makes the eurodollar yield curve approximately parallel to the U.S. Treasury yield curve. Eurodollar yields are separated from Treasury yields by a spread for credit risk and convexity differences.
The first chart in the series shown on “Liffe rates and yields” shows eurodollar futures contracts traded on Euronext Liffe on Aug. 28, 2008. Except for slight differences caused by the earlier closing time for the London exchange, the eurodollar futures quarterly rates and yields are the same as those listed by CME. Eurodollar futures traded on both exchanges result in smooth yield curves that are closely related to the curve of U.S. Treasury yields.
The remaining three charts on “Liffe rates and yields” are those for euribor, short sterling and euroswiss futures.
Euribor futures are referenced to the European Banking Federation’s Euro Interbank Offered Rate. NYSE Euronext states that the Liffe contract suite, which includes the euribor futures contract, an option on the futures contract and a one-year mid-curve option on the futures contract, accounts for more than 99% of euro-denominated STIR exchange-traded derivative money-market activity. The euribor futures contract is based on a three-month deposit of one million euros and has a minimum price movement of 0.005 (€12.50). A movement in the quarterly rate of one basis point represents a €25 change in the futures price.
Short sterling futures are based on £500,000, with a minimum price movement of £6.25 and a one-basis point change of £12.50. Euroswiss futures have a unit of trading equal to one million Swiss francs with a minimum price movement of one basis point, or 25 Swiss francs.
The euribor, short sterling and euroswiss charts show that their quarterly rates are arranged in a sequence that makes the resulting yield curves smooth. It is interesting to note that at this time eurodollar and euroswiss yield curves are rising with longer maturities, the euribor and short sterling indicate corresponding risk-free yields that are declining with increased maturities.
The smaller number of quarters listed for the Liffe contracts limits the comparison with the full 40 quarters of CME eurodollar futures. For euroswiss, the risk-free government bond yield at two-year maturity is 2.22%. This point is not shown on the euroswiss chart; however, the approximate 60-basis point spread between the Swiss risk-free yield and the yield generated by euroswiss quarterly rates falls in the same range as the spreads for eurodollar (100 basis points), euribor (60 basis points) and short sterling (80 basis points).
ENTER THE OPTIONS
For the higher trading volume options, euribor and short sterling, Liffe lists call and put contracts for a number of strike prices. “Euribor calls” and “Short sterling calls” show options for December 2008 and December 2009 expirations. On these charts, futures prices and call prices are divided by the strike prices so that all of the options can be compared on a relative basis. The decrease in option price premium is shown on both charts as the December 2008 calls approach the zero price along the horizontal axis or the intrinsic value starting at futures price/strike price equal to 1.00. Euribor calls show premiums lower than those for short sterling as traders view the approaching December 2008 expiration date.
The Liffe exchange carries a 10-day history of option price data. This short-term daily archive is used to create “Eurodollar and euroswiss calls”. Option price curves generated by combining several days of prices have a smaller horizontal span (for example, just 0.04% plus or minus from the strike price for euroswiss calls).
A single strike price with several underlying futures prices at different times can be used to create a “moving average” option price curve, so that by dropping the oldest data and adding new prices daily, or even minute-by-minute during the trading day, a new price that deviates from the expected value stands out immediately. This can be an effective strategy when applied to any set of options on futures or equities.
COMPARING TIME VALUES
The premiums and relative implied volatilities for eurodollar, euribor, short-sterling and euroswiss calls on June 10, 2008, are shown on “Volatilities compared.” The options having the highest relative premiums are those for short-sterling, followed by euribor, eurodollar, and euroswiss. Call price premiums divided by the strike prices are considered relative measures of underlying futures volatility by showing the height of an option price curve at the strike price. On June 10, short-sterling had the highest implied volatility while euroswiss had the lowest volatility and time value.
Euronext Liffe and CME Group together provide a wide range of STIR futures and options for hedging and speculation. The charts shown here indicate that the same pricing techniques and hedging strategies apply equally to U.S. and European contracts. Because of differences in trading hours and underlying interest rate structures in respective countries, there should be many opportunities to apply the pricing models in rate and price spreads and exploit any inefficiencies revealed by doing so.
Paul Cretien, CFA, is an investment analyst and financial case writer. E-mail him at PaulDCretien@aol.com.