The eurodollar futures market is impressive in its ability to perform several tasks simultaneously. Eurodollar futures quarterly interest rates must create a separate yield curve that matches the yield curve of U.S. Treasury securities (see “Yields and rates,” below), and at the same time allow for eurodollar futures’ higher risk and lack of convexity.
Eurodollar futures quarterly rates that are used to compute the eurodollar yield curve should also match the shape of a hypothetical curve of quarterly rates for U.S. Treasury securities. The Treasury quarterly rates would be lower than eurodollar rates, given their risk-free status.
Quarterly Treasury rates and eurodollar yields are both notional concepts. They may be shown on a chart, but cannot be traded directly; however, this does not mean that they are of no use to traders in the futures market. One trading technique is explored in “Swaps vs. eurodollar spreads” (Futures, August 2008). The yield on five-year interest rate swap futures is used to compute the price of the swaps futures contract as the present value of futures cash flows from semi-annual interest payments and principal to be received at maturity.
For the same five-year maturity, there is a eurodollar futures contract at the 20th quarter. The difference between the two futures is that the eurodollar futures contract is priced by subtracting its quarterly rate from 100. There is no direct market price, but just the price change at $25 per basis point (1/100 of one percent) of movement in the quarterly rate.
The tradable connection between the five-year eurodollar futures and the five-year interest rate swap futures is caused by the high correlation between their yields. Although the eurodollar yield is not directly used to price the futures contract in the same way that the swaps yield is used to price the interest rate swap futures, it is still an important factor in determining the market price of the eurodollar futures at quarter number 20, the five-year maturity.
WHEN YIELDS DIVERGE
“Three five-year yields” shows the closeness of the yields of five-year maturity eurodollar futures and interest rate swap futures from Feb. 19, 2008, through Feb. 6, 2009. Eurodollar and swap yields are shown at the top of the chart, while the series at the bottom is the five-year Treasury yield over the same period.
Differences between the eurodollar and swaps yields are usually small at any time. Most of the yield spreads fall within a range of five basis points, with eurodollar yields generally higher than the yields on interest rate swap futures. However, there are times when the eurodollar yield less swaps yield difference is less than zero, and other times when the difference is more than five basis points on the positive side.
Because the eurodollar less swaps yield spread usually falls between zero and plus-five basis points, a variation either below zero or above five may be used as a trading device. A large positive difference implies that the eurodollar yield is relatively high, with the possibility of an increased price for the five-year eurodollar futures as its yield returns to normal and carries with it a decline in the quarterly rate. The eurodollar futures would be traded long against a short-sale of five-year swaps at a two-to-one ratio of eurodollars to swaps futures.
On the other hand, any minus difference would indicate that the five-year eurodollar yield is relatively small, and that the spread trade should be reversed, shorting five-year eurodollar futures and taking a long position in five-year interest rate swap futures.
This strategy does not protect against a continued increase above plus-five basis points or against a continued decline below zero. However, it does assume that any deviation away from the range will be corrected within a reasonably short time. The relatively narrow range of variations in the yield spread means that traders are already taking advantage of the eurodollar and swaps contracts at the five-year maturity. These trades provide the “magnet” that brings the spread back to the range of zero-to-five basis points.
The potential success of a eurodollar/swaps spread trade may be estimated based on the sample of 152 days from Feb. 19, 2008, through Feb. 6, 2009. Of the 152 variations, 30 fall outside the five-basis point normal range, 14 above plus-five basis points and 16 negative variations. Twenty-one of the 30 variations would have resulted in profitable trades, while nine resulted in losses.
Of the nine losing days, four occurred from Oct. 7 through Oct. 10, 2008, as positive variations continued to increase each day. “Cumulative spread gain” (above) shows the gain from the spread of holding two five-year eurodollar futures against a short sale of one five-year interest rate swap futures from Feb. 19, 2008, through Feb. 6, 2009. The plunge in spread gains in October 2008 matches the timing of losses that would have been incurred in the hypothetical trades.
MAJOR ATTRACTION
A primary force that underlies gains and losses from the eurodollar/swaps spread is the flexing action of ratio of the eurodollar five-year quarterly rate to the computed eurodollar yield for the same quarter. The eurodollar and interest rate swap yields are closely related, with the ratio of rate-to-yield for the 20th quarter inversely related to the spread profit. Eurodollar futures contracts are priced by the quarterly rate, as 100 less the rate, rather than by the yield. However, at the five-year maturity, the rate must be a value that allows the eurodollar yield to fall close to the swaps yield.
“Rates-to-yields” shows how this ratio has flexed on four dates in 2008 and 2009. On March 17, 2008, and Feb. 6, 2009, the ratios were comparatively high at 1.463 and 1.450. On these dates the cumulative spread gains were $768 and $1,275, respectively. Lower ratios of 1.223 on April 25, 2008, and 1.050 on June 19, 2008, are related to cumulative gains of $2,846 and $4,128.
Multi-tasking extends to the quarter-to-quarter change in the difference between eurodollar rates and yields. The changes are shown on “Seasonal effects.” The seasonal differences should have a one-time effect on eurodollar-swaps spread when the transition to a new 20th quarter takes place in March 2009. Currently, the nearest quarter is March 2009 and the 40th quarter is December 2018, with December 2013 as the five-year maturity. Following the disappearance of March 2009, the next quarter will be June 2009 and the five-year maturity will be March 2014. The “Seasonal effects” chart shows a six basis point decline in the difference in the rate and yield between December 2013 and March 2014.
On Feb. 6, 2009, the computed yield for the five-year interest-rate swap futures is 2.622%. The eurodollar futures yields for surrounding quarters are 2.59, 2.65, and 2.71 for September 2013, December 2013 and March 2014, respectively. Shifts caused by the seasonal transition should be taken into account in estimating relative price changes for the eurodollar/swaps because the December-to-March negative movement is normally the largest and most predictable of the four quarterly changes.
While only one futures maturity is used to compute the spread results shown on “Cumulative spread gains,” it is possible (and even likely) that traders use several eurodollar contracts to spread against interest-rate swap futures. The use of multiple futures would lessen the impact of a single rate or yield combination having an unusual or unpredictable change.
The use of the word “multi-tasking” in the title of this article goes beyond finding the proper metaphor. Eurodollar quarterly rates, computed yields, prices, seasonal effects and related balancing with U.S. Treasury yields, nominal yields on T-note futures and yields on interest rate swaps must all continuously be maintained in harmony. The dictionary’s definition of multi-tasking refers to simultaneous computer operations, and this is obviously a good comparison and description of the eurodollar futures market.
Sudden unexpected movements in U.S. Treasury yields and other market rates are to be expected in this period of financial and economic turmoil. The exact effect of these events on yield differences and spread gains or losses cannot be predicted; however, the basic “rules of the game,” some of which are described above, should continue to provide trading opportunities with reasonably low risk.
Paul Cretien is an investment analyst and financial case writer. E-mail him at PaulDCretien@aol.com
