From the July 01, 2011 issue of Futures Magazine • Subscribe!

Government bond yields and forward rates

Four currently-traded interest rate futures contracts are shown on "90-day interest rate futures" (below). In addition to Eurodollar rates listed by CME Group, these include euribor, NYSE Liffe Eurodollar and short-sterling futures. Although they start at different rates, the four contracts converge at approximately 4% after 16 quarters on April 14, 2011. With the Federal Reserve holding U.S. rates for one-quarter delivery dates at extremely low levels, the 1.50% euribor rate (for 90-day euro-related rates) looks surprisingly high in comparison. The shortest-term rate on 90-day sterling futures is in the middle at 1.00%.

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The curves of 90-day rate-to-yield ratios also vary between interest-rate futures markets. These are the "flex" curves described in "Eurodollar futures: Rate, yield and price structures" (May 2010). When interest rates are at a low level, as they currently are in the United States, the ratio of rates-to-yields will increase. As shown on "Ratios of rates to yields" (below), on April 19, 2011 Eurodollar futures rates topped a two-to-one ratio over yields at approximately the two-year, or eight-quarter, mark in number of quarters to maturity. At the same time, the ratios for the European Central Bank (ECB) on average increased from 1.0 to 1.4.

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Tracing ratios

The ratio of rates-to-yields is not a predictor of rate changes, but can be an important factor when rates change. As interest rates rise in the United States — which they invariably will do at some point — the ratio will fall, rewarding long positions in Eurodollar futures over a range of expiration dates compared to the more stable yields on T-note and interest rate swaps futures at the same maturities.

On April 22, 2011 the price of a five-year T-note futures contract was 116-07, or $116,227, with a yield of 2.525%. An immediate increase of 100 basis points in yield would result in a new price of $111,255 — down $4,972 due to the increase in yield. A spread trade using a two-to-one ratio of March 2016 Eurodollar futures against the five-year T-note produces a slight loss, with the long-side Eurodollar futures down 2 x $2,500. However, "Ratios of rates-to-yields" shows that the increase in yield should be accompanied by a decrease in the rate-to-yield ratio from 1.80 to 1.40 or lower. This should give an edge in trade results to the long Eurodollar futures as they lose less than the short T-note futures.

At any time, the structure of Eurodollar yields at different maturities is determined by the sequence of short-term (quarterly) rates, with the underlying objective of matching the U.S. Treasury yield curve. The same process is at work in different interest-rate markets, although the levels of rates, yields and ratios of rates-to-yields vary.

Whether or not a trader believes that interest rates can be predicted by looking at forward rates or the yield curve — or whether changes in government bond yields precede or follow shifts in forward rates — it still is worthwhile to observe the relationships between quarterly rates and yields at various maturities. Changes in the curves of quarterly rates, forward rates or longer-term yields provide the speculative profits and losses as well as the benefits of hedging that are the underlying reasons for the existence of the market for interest-rate futures and options.

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

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