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

Eurodollar options: Interest rate forecasts and calendar spreads

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%.

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