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.
Forecasting future rates
In any option market, prices depend on the volatility of underlying assets as perceived by the market. Without price variations, options have no value; thus, every call and put price is related intrinsically to the market’s forecast of future high-low price spreads for the underlying.
"Breakeven rates" (below) presents the high-low interest rate spread for the five expiration dates related to Eurodollar call options at the 0.380% strike rate on Oct. 17, 2011. Also shown are the delta values (slopes of the price curves at 0.380% strike) and the current quarterly rates. The breakeven rates show the rates at expiration that will produce zero profit or loss from a hedge trade that holds Eurodollar calls against a short position in the underlying Eurodollar future. The number of options held against the futures contract is determined by the slope, or delta value, at the specific strike rate. Low rates in the forecast spreads do not increase greatly over time, while the high rates show a significant increase.
Market forecasts such as those shown on "Breakeven rates" generally are conservative regarding future interest rate changes, although with the current state of the U.S. economy together with a recent announcement by the Federal Reserve chairman that rates would be kept low for the near future, the high breakeven rate of 1.364% may be correct. Leading to Oct. 21, 2011, recent high and low rates for the December 2012 Eurodollar futures contract have been approximately 1.10% to 0.40%.
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.
Because interest rate futures are tied firmly to the current U.S. Treasury yield curve, they cannot produce good forecasts of future rates. Their main roles are in hedging against interest rate changes and in speculative trading. As shown earlier, options on Eurodollar futures are ideal for predicting the possible high-low spread of rates leading to the expiration date.
On "Yields and rates," the close correlation between Eurodollar yields and the yield on interest rate swaps at the five-year maturity suggests a possible spread trade — one swaps contract against two 20th quarter Eurodollar futures. The two-to-one ratio of Eurodollar futures to interest rate swaps is based on the comparative price changes for a one-basis-point change in the interest rate. On Oct. 21, 2011, at a price of 111-30.5, or $111,953, the price change for a one-basis-point increase or decrease in yield is $51. For Eurodollar futures, the same 0.01% shift in the quarterly rate produces a $25 price change.
Whereas Eurodollar futures change in price because of a change in the quarterly rate, interest rate swaps futures are priced according to annualized yield. The Eurodollar-swaps spread relates to Eurodollar quarterly rates being structured so that the computed Eurodollar annualized yields are close to the U.S. Treasury yields. At the same time, they are adjacent to the yields on T-note futures and swaps futures at the same maturities. For example, at the five-year maturity the Eurodollar yield on Oct. 21 is 1.52% and the swaps yield is 1.51%.
The final key to the Eurodollar-swaps spread trade is the ratio of Eurodollar rates to yields. On "Eurodollar rate-to-yield" (below), the ratio at 20 quarters is approximately two-to-one. The current height of the curve is caused by relatively low market rates of interest. When rates increase with an economic recovery or inflation, the rate-to-yield curve will fall. Because Eurodollar rates at the five-year maturity will decline while the yield on interest rate swaps is more stable near the Treasury yield curve, a spread that holds long Eurodollar futures against short swaps futures should gain because of the drop in rate-to-yield.
The large trading volume and completely organized pricing structure for interest rate futures should make it possible to create the suggested calendar spreads, Eurodollar-swaps spreads and interest rate forecasts in any interest rate and yield environment.
Paul Cretien is an investment analyst and financial case writer. His e-mail is PaulDCretien@aol.com.
