From the January 01, 2012 issue of Futures Magazine • Subscribe!

Eurodollar options: Interest rate forecasts and calendar spreads

Some whispers have been heard in the market recently, tentatively asking whether the extremely low interest rates resulting from Federal Reserve policies really are working to help the U.S. economy out of its multi-year recession. Whether or not the present rate structure is helpful, hedgers and traders use interest rate futures for profit and protection from adverse shifts in rates and yields. Interestingly, several Eurodollar-based tools can do double duty — reducing interest rate risk and creating a positive return on interest rate trades.

"Eurodollar call options" (below) shows the price curves for five quarterly sets of call options on Eurodollar futures, beginning at the December 2011 expiration and going through December 2012. The curves include 20 premiums per contract, computed by a regression equation based on five calls for each of the futures.

Call option premiums are shown increasing as the strike rates increase. Because the conventional way to express Eurodollar futures prices involves subtracting the quarterly interest rate from 100 (a rate of 5.25% results in a 94.750 price), calculations quickly become unwieldy because the quarterly rate is small compared to the price. It is easier to consider that calls on Eurodollar futures are the same as put options on quarterly rates. Thus, instead of the usual strike prices, the calculations use strike rates, and as with put options, the premiums increase as the strike rates rise relative to the underlying futures rate.

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