From the May 01, 2010 issue of Futures Magazine • Subscribe!

Eurodollar futures: Rate, yield and price structures

Structure #4 is the curve of eurodollar quarterly price changes for the 40 eurodollar futures quarterly contracts between two dates. As the foundation for the price change structure, “Rates-to-yields” (page 44) shows the curve of eurodollar quarterly rates-to-yield ratios on three days: Jan. 7, 13 and 19, 2010. Because of the relatively short time span, the curves are closely related, adding height as the ratios increased during this period.

If the yield curve and rate/price curve are stable, “Rates-to-yields” implies that, over time, eurodollar contracts on the left side of the rate/yield peak should have rates that fall, while rates on the right side should rise toward the peak at the eighth quarter.

Depending on the relative stability of the rate/yield curve and the underlying eurodollar /yield curve, contracts on the right side should gradually reach the peak and start down the left side toward a ratio of 1.0 near the delivery date.


When other factors remain constant, contracts on the left side should continuously gain value compared to contracts on the right side. The problem is that other factors do not remain constant. As market rates change, the curve of eurodollar rates-to-yields shifts in response, causing flexing movements that affect the results of potential calendar spreads.

Structure #4 is shown on “Price changes, falling rates”. Prices are increasing for all 40 eurodollar futures contracts as market interest rates fall – first from Jan. 7 to Jan. 19, 2010, and then from Jan. 13 to Jan. 19. Beyond the five-year maturity, price changes appear to become less organized; however, it is normal for price changes in the final five years of eurodollar futures to appear as a tail being wagged by the first 20 quarters.


“Price changes, rising rates” illustrates the impact of increasing interest rates over several days. As quarterly rates increase, the chart of price changes from June 6 to June 17, 2008, shows the largest price decline for contracts with maturities at approximately four quarters.

Observations
The price change charts confirm that market-driven eurodollar rates and prices occur within the first 20 quarters, with the following five years of quarterly rates and prices being produced by computer models that result in eurodollar yields that parallel the U.S. Treasury yield curve, while maintaining the seasonal pattern of rates shown in Structure #3.

Structure #4 suggests that speculative eurodollar trades should concentrate on maturities around eight quarters because these tend to have the greatest range of plus and minus price changes. “Price changes, falling rates” illustrates the progression in price change for the eighth quarter from 23 to 35 basis points over the additional six days from Jan. 7 to Jan. 13, 2010. With the shape of price change curves remaining relatively constant over a period of several days, trades that depend on differing volatilities between specific maturities may be planned and executed.

Because of the rate-setting and pricing connections to the U.S. Treasury yield curve as shown by eurodollar futures rate and price Structures #1, #2, and #3, the price changes of Structure #4 are part of a system that is coordinated with Treasury yields.

The progression of influence from Treasury securities to eurodollar futures is the following: 1) the market establishes yields on U.S. Treasury bonds and notes; 2) T-note futures are priced to yield slightly above Treasury yields at several maturities including five-years; 3) eurodollar futures at the 20-quarter maturity are priced to yield slightly above five-year T-note futures with variations generally within zero to five basis points above the T-note yield and 4) eurodollar quarterly futures contracts are traded primarily over the first 20 quarters, with the highest rate and price volatility occurring near the halfway point between the shortest maturities whose rates are set according to variations in London Interbank Offered Rate and a point (near the 20-quarter maturity) at which market pricing fades out and more automatic programmed pricing begins.
The four eurodollar rate, yield and price structures describe predictable and measurable connections for different aspects in this popular futures market.

Knowledge of the hidden rate, yield and price structures of eurodollar futures should assist in determining when calendar spreads are available, which maturities are most favorable for speculation, and what price changes may be caused by rising and falling market rates of interest as well as movements in U.S.
Treasury yields.

Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.

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