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

Eurodollar options: Interest rate forecasts and calendar spreads

Calendar spreads

On "Price spreads" (below) the spreads of dollar premiums between December 2012 and September 2012 Eurodollar calls are shown for four strike rates: 0.25%, 0.38%, 0.50%. and 0.63%. The exhibit also shows the premiums for March 2012 and December 2011 based on the same four strikes. Expiration dates for both pairs are separated by 91 days. The price curves for the four expiration dates on "Eurodollar call options" illustrate the increasing spread between near-term and farther-out expiration premiums as the time to expiration evaporates. For initiating a spread trade it is important that the two longer-term curves be close together so that a widening of the original spread is imminent.

For example, if no other changes occurred in the market between the present date and summer 2012, we might expect the spread on the 0.38% strike rate between September and December 2012 to increase from $12.50 to $37.50, according to the "Price spreads" chart. Aside from significant shifts in the yield curve, options that are closer to expiration should continue to fall faster than longer-term options, increasing spreads for many strike rates.

On Oct. 29, 2011, the December-September 2012 0.38% strike spread was $50 ($212.50 – $162.50), an increase of $37.50 in 11 days with 325 days remaining to expiration for the September 2012 options. The rapid increase shows that spread variations may be substantial. A trader should be prepared to take profits early. Fast turnover with moderate gains may be the best strategy.

Caution is necessary near the expiration date because of gamma risk — the increased sensitivity of at-the-money options to changes in the underlying, which can reduce or eliminate the premium spread between the longer- and shorter-term options. For this reason, it is best to close out the calendar spread several weeks before the expiration date.

In addition to calendar spreads, there are other spreads based on current relationships between Eurodollar futures and futures contracts on Treasury bonds, T-notes and interest rate swaps. As shown on "Yields and rates" (right), Eurodollar quarterly rates — like forward rates on Treasury securities — convert into annualized yields that are closely parallel to the U.S. Treasury yield curve. T-note yields and interest rate swap yields on this chart also are grouped around the Treasury yield curve.

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