Now that interest rates in the United States seem to be approaching a long-term bottom, this is a good time to consider the types of trades that can take advantage of an upward trend in rates and yields.
Short positions could be taken in various interest rate futures including eurodollar contracts, interest rate swaps and Treasury futures. Alternatively, spreads between eurodollar and interest rate swap futures or Treasury-note futures provide some protection from extremely negative results by balancing long and short positions on interest rates.
Spread traders look at two or more futures contracts whose prices are closely related and then exploit small divergences from their normal relationships over reasonably short time spans. There are several ways in which the separate futures could be connected — for example, one commodity might be the raw material for another, one commodity may have multiple calendar spreads or the two may have regulatory boundaries that tend to tie their prices together or — as in the case of eurodollar futures, interest rate swaps and Treasury-note futures — prices vary in response to another variable. For these three futures the underlying determinant is the yield on U.S. Treasury securities.
Trade what you know
The closer and more predictable the relationship between the two legs, the better the potential for spread profits. Variations around a normal or average spread in rates or prices may be small or large, and this is the point at which the trader’s experience with the two contracts will help determine whether an individual trade results in profit or loss. Decisions include how far a variation may stretch before changing direction and returning to normal.
"Three five-year yields" (above) shows yields-to-maturity for five-year (20th quarter) eurodollar futures, five-year interest rate swaps and five-year U.S. Treasury securities from June 14 to Aug. 31, 2010. The yields are found by the following three methods:
- The yield for eurodollar futures at the five-year maturity is based on the geometric mean of 20 quarterly rates — that is the yield to maturity resulting from successive investments in the first 20 quarterly eurodollar futures.
- Yields on five-year interest rate swaps are the discount rates needed to cause the present values of 10 semiannual payments of $2,000 and $100,000 received at the end of year five to equal the quoted price.
- U.S. Treasury yields at the five-year maturity are listed by Bloomberg.com for individual bonds and notes.
The sequence of cause-and-effect involved with the eurodollar/swap spread is the following: (1) Variations occur in the yield curve of U.S. Treasury securities resulting in the five-year maturity yield increasing or decreasing. (2) The yields on interest rate swaps and eurodollars at the five-year maturity rise or fall as the result of a change in the Treasury yield. (3) Yields on eurodollars and interest rate swaps tend to move in tandem, but the eurodollar yield is usually larger and has greater volatility (thus, a tendency to move too far up or down with respect to the swap yield’s change). (4) Because the eurodollar and swap yields eventually move back toward a normal spread, trades involving opposite long and short contracts may be profitable.
When the eurodollar yield rises too far above the swaps yield, the spread trade implies buying the 20th quarter eurodollar future while selling the five-year swap because the eurodollar rate must fall to bring about the needed correction in yield. On the other hand, variation of the eurodollar futures yield lower than normal suggests selling eurodollar 20th quarter futures and buying five-year swaps. Relative to swaps, eurodollars may be counted on to return to a smaller spread position as traders find that the distance between the two futures has become too large. Purchases or sales of eurodollars are balanced against the more stable interest rate swaps with the expectation of a narrowing spread between the two.
An important question is "What is the ‘normal’ spread between the eurodollar and swaps yields?" The chart "Ratios to moving total average" (below) shows one approach to finding the proper direction for eurodollars — interest rate swaps spread trades. The differences between the yields on five-year swaps and U.S. Treasury securities on each day are divided by the average of the differences from June 14 through the current date. This averaging method replicates the experience of an investor who begins spread trades on June 14 and continues through Aug. 31. By the end of the series, the differences are averaged over a total of 51 days.
On "Ratios to moving total average," the same averaging technique is applied to the differences between the yields on eurodollar and interest-rate swaps five-year futures. Yield differences between swaps and Treasury securities tend to be much smaller and closer to the moving average than differences between yields on eurodollars and interest-rate swaps. Plus or minus variations of eurodollar yields away from swaps yields are corrected by the two yields moving closer together.