"Daily gain or loss on spread" (below) shows the results from spread trades in which one 20th quarter eurodollar futures is long or short against the opposite position in a five-year swaps contract at the end of each day. The positions are closed out the following day and a new trade is initiated. Results shown are based on price changes only and do not consider the cost of trading (such as commissions). Each day’s trade is determined by whether the ratio to moving total average for the eurodollar contract is above or below the corresponding swaps ratio. Thus, the size of the spread is not considered — only the direction of the initial variation.
Overall, the spread results show approximately twice as many gains as losses with the total profit on "Cumulative gain on spread" (above) equal to $3,162. It is also worth noting that because of the continued decline in interest rates and yields, as indicated by "Three five-year yields," simply taking long positions in either eurodollar futures or interest-rate swaps over the period from June 14 to Aug. 31, 2010 would have produced similar profits. However, spread trades assume that the trader does not know the price trend in advance. The indicated spreads might have been profitable whether interest rates were rising or falling.
A modified version of the spread trades requires a day-to-day shift from a positive spread to one that is negative, or vice versa, before making a trade. Thus, on a given day there might be no trade while the cumulative gain or loss continues to show the value following the previous trade. This lower risk strategy produced a cumulative prospective gain of $2,848.
In "Swaps versus eurodollar spreads" (August 2008) it was shown that the ratios of eurodollar rates-to-yields over the 40-quarter span of eurodollar maturities form a curve that flexes with the level of interest rates. Periods of higher rates correspond with lower "flex" curves, while lower rates produce higher curves.
"Eurodollar flex curves" (below) shows rate-to-yield ratios on four dates beginning on April 25, 2008. Because interest rates are historically low in 2010, flex curves for Jan. 13 and Aug. 31, 2010, are high — with ratios peaking at near 2.0. In August 2010, the rate-to-yield flex curve was stable; however, with increasing yields the curve should decline, tending to reduce the price decline in eurodollars while rates increase. For example, when the yield is 3%, a shift from 1.90 (with the rate equal to 5.7%) to 1.20 (with a 3.6% rate) would result in a price increase for the five-year eurodollar futures of $525, corresponding to a reduction of 21 basis points in the eurodollar quarterly rate.
The spread results on "Daily gain or loss on spread" and "Cumulative gain on spread" are based on a one-to-one ratio of long or short eurodollar contracts to the opposite position in swaps. In the 2008 analysis, it was suggested that two eurodollar futures could be used to spread against one interest rate swaps contract at the five-year maturity.
The reason for the two-to-one ratio is that a rate change of one basis point in the eurodollar futures contract produces an opposite price change of $25, while a one basis point shift for five-year interest-rate swaps results in a price change of approximately $49. A reason for not using the two-to-one ratio is that swaps and eurodollar futures do not respond to the same underlying rates and yields — on a given day the two contracts may move in the same direction or change in completely different ways.
Interest-rate swaps are priced in correspondence with the U.S. Treasury yields at the same maturities. For swaps, the yield at the five-year maturity determines the price. In contrast, eurodollar price changes occur when the quarterly rate (reflecting invisible forward rates underlying U.S. Treasury yields) increases or decreases. The rate moves up or down to keep the eurodollar five-year yield in close correspondence with the yields on five-year swaps and Treasuries. Although the shortest-term eurodollars are tied to Libor, with increased maturities five- and 10-year eurodollar rates and yields become increasingly dependent on the U.S. Treasury yield curve.
One result of the differences in pricing eurodollar and swap futures is that eurodollar futures prices are more variable than the prices on interest-rate swap futures. This is a feature of the spread trade between eurodollar futures and interest-rate swaps that generates cumulative profits when market rates are falling. A chart such as "Ratios to moving total average" assists in determining whether eurodollars should be bought or sold for the day’s spread trade. It is possible that similar gains may be made with a change in direction of the spread when interest rates begin to rise.
Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.