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%.


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.


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

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