Over the past year, Federal Reserve monetary policy has kept the shortest-term rates at historically low levels. There are sound economic reasons for this strategy, including the encouragement of bank lending in an effort to put the ailing U.S. economy back on its feet. However, the decline in rates to the present level was not easy on many commercial banks. Their funding costs trailed the drop in variable lending rates, compressing profit margins.
Now at the bottom of the rate structure, it’s easy to assume that banks are adjusting borrowing and lending rates to get margins back to normal. At the same time, bank managers have learned a lesson in providing floor rates for floating-rate loans. Bankers and others for whom interest rates are an important part of hedging and speculating are now looking at the low rates and assessing the probability of near-term increases toward more typical short-term interest rates and yields.
Think the only way for rates to move is up? Not so fast. There have been occasions in the history of futures and equities markets when there was overwhelming market sentiment or consensus that certain events would probably occur. The current forecast of changes in short-term interest rates must be considered a prime example of a market consensus related to the immediate past rate and price movements instead of forward-looking.
One way to assess market thinking about interest rates is to look at options on eurodollar futures. Interest rate futures contracts on 90-day deposits of U.S. dollars in foreign banks cover 40 forward quarters and are each priced as 100 less the current 90-day interest rate related to the future time period. For example, on April 16, 2010, the September 2010 eurodollar futures closing price was 99.530, showing a 90-day rate equal to 0.47%.
As the 90-day rate declined from Jan. 4 through April 1, 2010, the September 2010 futures gained from 98.995 to 99.455, a total change in price of $1,150 at $25 per basis point. Continuing through April 16, the rate declined another 7.5 basis points to increase the gain since Jan. 4 by an additional $187.50.
The market’s opinion on further increases in the September 2010 eurodollar futures may be evaluated by looking at the ratio between call and put premiums on options on April 16. As listed by Barchart.com, the ratio for that day was 247.88, with total call premiums of $570,131.75 vs. $2,300 of put premiums.
“Ratios of call to put premiums” (below) shows that the consensus opinion for eurodollar interest rate futures (as measured by the call/put ratio for September 2010 contracts) is much stronger compared to the consensus for assets underlying other futures. The assumption here is that the strength of consensus may be measured by the ratio of call/put premiums.
When rates rise
Thus far, the description of market consensus has focused on the short-term history of eurodollar rates from January through mid-April, during which time futures rates fell and prices increased. Now think of the longer-term future, when the Federal Reserve’s emphasis on keeping rates low becomes a distant memory and interest rates resume unrestricted movements.
When rates increase, eurodollar futures prices will fall at $25 for each basis point. In other words, trading on the rate is equivalent to trading with puts on the eurodollar futures quarterly interest rate. The put price will fall when the rate increases. On the other hand, when the rate decreases, the put price goes up -- and this is what happened to calls on eurodollar futures prices (and to the equivalent puts on the eurodollar rate) from Jan. 4 through April 16, 2010.
An alternative consensus is that interest rates are so low at the present time that they must eventually change direction and head higher. Although the timing is uncertain, the probability is surely high that this will occur. In the meantime, the put options on eurodollar rates have become more valuable with declining rates. One question nags the valuation of puts, and that is the wall at rates equal to, or near to, 0%.
While call options may gain without limit as the underlying price increases, put options are generally limited because most assets will not have a negative price. This is the put price limit, or wall, blocking further gains once the underlying asset reaches the price of zero. For the eurodollar rate, this would be a short-term, 90-day, interest rate equal to 0%. With the September eurodollar futures rate equal to 0.47%, the put price wall is looming as a potential price barrier. Although officials at the central bank could make interest rates negative if they wished, they probably will not go that far.
The market is now
It is easy to understand why the near-term expirations of eurodollar futures would be caught up in the current environment of increasingly low short-term interest rates. But why should this consensus prediction of lower rates affect eurodollar futures with quarterly dates at least one and a half years in the future when rates are, in all probability, going to be higher than they are at the present time? The answer is that eurodollar futures are always geared to present market rates, especially to yields on U.S. Treasury securities and Treasury note futures in the current time period.
All eurodollar quarterly rates will respond immediately to today’s interest rate movements. This relationship is made clear on “Eurodollar rates and yields” (below). The chart shows that on April 16, 2010, eurodollar quarterly yields, generated by computing the geometric means of the quarterly rates, are closely tied to U.S. Treasury yields. On that date, the spread between the eurodollar yield and Treasury yield averaged only 0.33%.
“Eurodollar call options” (below) shows option price curves for June 2010, September 2010, September 2011 and December 2011. On this chart, the futures rates, computed as 100 minus the futures prices, are listed on the horizontal axis and the dollar premiums along the price curves are related to the corresponding rates. Premiums are higher for the larger quarterly rates because these rates are subtracted from the strike prices that are listed as 100 less the quarterly rate, and the lower the strike price the higher the call option premium.
The prices for the two short-term 2010 options are higher than the two with 2011 maturities. This pattern is predictable from the curve of eurodollar rates shown on “Eurodollar rates and yields.” As the rate curve increases with longer maturities, the result is lower futures prices as well as lower premiums for calls on September and December 2011. Price curves for June and September 2010 are closely related with just 90 days separating their expiration dates; however, September and December 2011 are more closely related because the dots for the December calls cover those for September at each quarterly rate.
When the eurodollar futures are related to the ratio of the futures rate (100 minus the futures price) to the “strike rate” (100 minus the strike price) for each strike price on “Call options on eurodollar futures” (below), longer-term calls are shown in their proper position as higher in time value than shorter-term options. June and September are approaching the futures rate/strike rate of 0, a possible barrier against continued upward price movement.
It is noted on “Call options on eurodollar futures” that the September 2011 premiums have slightly higher time values than the December 2011 calls. As time to expiration approaches over the next four quarters, it should be expected that the September calls will fall relative to December 2011, so that their two option price curves will be positioned similarly to those for June and September 2010 at the current time in April 2010. The shape of the U.S. Treasury yield curve also will play a part in their relative valuation because of the close adherence of eurodollar yields to the Treasury yield curve.
On the move
Interest rates are typically in motion, reflecting changes in the national and global economic environments. When rates are held in check temporarily by central bank monetary policy, they are unable to perform effectively as a pricing mechanism for current and future debt. In effect, there is a vacuum, or hole, in the pricing process that will be filled eventually when the interest rate market is able to perform its normal functions.
Currently, there are signs of unusual market manipulation, starting with historically low market rates and yields in the United States and continuing with the unusually low spread of eurodollar yields over the U.S. Treasury yield curve.
A final indication of unusual pricing concerns the five-year, or 20-quarter, eurodollar yield, which may be measured by the average between 2.83% for the March 2015 futures and 2.93% for June 2015. The average of these two yields, 2.88%, is slightly lower than the 2.91% yield on five-year T-note futures. This makes it likely that a broad span of eurodollar rates will need to increase to pull the eurodollar yield above the T-note yield at the five-year maturity. The five-year yield on U.S. Treasury’s 2.5% coupon, March 31, 2015, on the same day was 2.47%.
A guide to eurodollar futures
The prices listed for eurodollar futures -- 100 less the rate -- are large enough to swamp the usual calculation of option price curves using the LLP option pricing model. A better alternative is to use the rates that create eurodollar futures price changes.
The below table shows 15 strike rates for the September 2011 eurodollar futures call options on April 16, 2010. Strike rates are defined as 100 less the strike prices listed by Barchart.com. For example, a listed price of 98.370 results in a strike rate of 1.630. When the strike rates increase, the call option premiums also increase.
The table shows the call premiums predicted by the LLP option pricing model at each strike rate, with the price curve shown on “Eurodollar call options.” To compute the change in the option premium for a one-basis point change in the rate at the current market rate of 1.74%, two additional strike rates are inserted between 1.63% and 1.75%. The change in premium from 1.73% to 1.75% is $28.16, or approximately $14 per basis point.
From the premium at 1.74%, $1,308, to zero would be a change of approximately 93 basis points, which would result in an estimated range of interest rates from 0.81% to 2.67% for September 2011. Although this may be a fair prediction of potential interest rates at that forward quarter, it also would imply that eurodollar futures are related to the future -- an assumption that is appropriate when relating eurodollar quarterly rates to the forward rates implied by the U.S. Treasury yield curve.
Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.
