INTEREST RATES
Understanding Eurodollar Futures
FEBRUARY 14,2013
John W.Labus zewski
Michael Kamradt
David Gibbs
Managing Director
Executive Dire ctor Directo r
Research&Product Development 312-466-7469 Interest Rate Products 312-466-
7473
Product Marketing 312-207-2591
CME Eurodollar futures have achieved remarkable success since their debut inDecember 1981.Much of this growth may directly be attributed to the fact thatEurodo llar futures represent fundamental building b lo cks o f the interest rate marketp lace.Indeed, they may be deployed in any number of ways to achieve diverse objectives.
This article is intended to provide an understanding regarding how and whyEurodollar futures may be used to achieve these diverse ends.We commence with somebackground on the fundamental nature of Eurodollar futures including a discussion ofpricing and arbitrage relationships.We move on to an explanation of how Eurodollarfutures may be used to take advantage of expectations regarding the changing shape ofthe yield curve or dynamic credit considerations.
Finally,we discuss the symbiotic relationshipbetween Eurodo llar futures and over-the-counter
(OTC interest rate swap s (IRS. In particular,Eurodo llar futures are o ften used toprice and to hedge interest rate swaps with good effect.
Pricing and Quotation
Eurodo llar futures are b ased on a$1 million face-value,3-month maturityEurodollar Time Deposit.They are settled in cash on the 2nd London bank business dayprior to the 3rd Wednesday of the contract month by reference to the British Banker’s
Association(BBA Interest Settlement Rate forthree-month Eurodollar Interbank Time Depo sits.
These contracts mature during the months o f March,June,Septemb er,or December,extending outward 10 years into the future.However, the exchange also offers“serial”contract months in the four nearby months that do not fall into the March quarterly cycle.See Table 1 below for contract specifications.
Where once trading was largely conducted on the floor of the exchange usingtraditional open outcry methods during re gular daylight hours–today, trading activity islargely conducted on the CME Globex®electronic trading platform on nearly an aroundthe clockbasis.
These contracts are quoted in terms of the“IMM index.”1 The IMM index is equalto 100 less the yield on the security.
=100.000−
E.g., if the yield equals 0.750%, the IMM index is quoted as 99.250.
=100.000−0.750%=99.250
Ifthe value of the futures contract should fluctuateby one basis point(0.01%, this equates to a$25.00 movement in the contract value.This maybe confirmed by calculated the basis point value
(BPV of a$1 million face value,90-day money market instrument into the followingformula.=#0.01%=$1,000,000#0.01%=$25.00
The minimum allowable price fluctuation,or“tick”size, is generally established at one-half ofone basis point,or 0.005%.Based on a$1 million face-value 90-day instrument, this equates to$12.50.However, in the nearbyexpiring contract month, the minimum price fluctuation is set at one-quarter basis point,or 0.0025%,equating to$6.25 per contract.
1
The IMM,or International Monetary Market,wasestablished as a division of the CME many years ago.
The distinction is seldom made today because CMEoperates as a unified entity,but re ferenc es to IMMpersist today.
500,000
1,000,000
1,500,0002,000,0002,500,0003,000,000
3,500,000
4,000,0002000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
Eurodo llar Average Daily Vo lume
Futures Options
As seen in Table 2 below,March 2014 Eurodollar futures advanced by 1.5 b asispoints on January 30,2013 to settle the day at a price of 99.49.Noting that each basispoint is worth$25 per contract based on a$1 million 90-day instrument, this implies anincrease in value of$37.50 for the day.
Shape ofYield Curve
Pricing patterns in the Eurodollar futures market are very much a reflection ormirror of conditions prevailing in the money markets and moving outward on the yieldcurve.But before we explain how Eurodollar futures pricing patterns are kept in lockstepwith the yield curve, let us consider that the shape of the yield curve may be interpretedas an indicator of the direction in which the market as a whole believes interest rates mayfluctuate.
Three fundamental theories are referenced to explain the shape ofthe yield curve–(1 the expectations hypothesis; (2 the liquidity hypothesis;and, (3 the segmentationhypothesis.
Let’s start with the assumption that the yield curve is flat. I.e., short-term andlonger-term interest rates are equivalent and investors are expressing no particularpreference for securities on the basis of maturity.The expectations hypothesis modifiesthis assumption with the supposition that rational investors may be expected to alter thecomposition of their fixed-income portfolios to reflect their beliefs with respect to thefuture direction o f interest rates.
Thus, investors move from long-term into short-term securities in anticipation ofrising rates and falling fixed-income security prices,noting that the value of long-terminstruments reacts more sharply to shifting rates than short-term instruments or by
moving from short-term into long-term securities in anticipation of falling rates and risingfixed-income prices.
Yields expected to rise Yield curve is steep
Yields expected to fall Yield curve is flat or inverted
In the process of shortening the maturity of one’s portfolio, investors bid up theprice of short-term securities and drive down the price of long-term securities.As a result,short-term yields decline and long-term yields rise- the yield curve steepens. In theprocess of extending maturities, the opposite occurs and the yield curve flattens or inverts.
2
The liquidity hypothesis modifies our initial assumption that investors may generallybe indifferent between short-and long-term investments in a stable rate environment.Rather,we must assume that investors generally prefer short-over long-term securities tothe extent that short-term securities roll over frequently,offering a measure of liquidityby virtue of the fact that one’s principal is redeemed at a relatively short-term maturityd ate.
As such, long-term securities must pay a liquidity premium to attract investment,and long-term yields typically exceed short-term yields,a natural upward bias to theshape of the curve.
Finally, the segmentation hypothesis suggests that investors may be less than fullycapable of modifying the composition oftheir portfolios quickly and efficiently in order
to take advantage of anticipated yield fluctuations. In particular, investors sometimes faceinternally or externally imposed constraints: the investment policies of a pension
2 Although these observations are generally true, they may not be absolutely true.
E.g., the Fed had been pushing short-term rates higher in early 2005 while longer-termrates remained relatively stable.As such, the yield curve was in the process of flatteningwhile many analysts still expected the Fed to continue tightening.
0%
1%
2%
3%
4%
5%
6%
3
-
Mth
6
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1-
Yr
2-
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3-
Yr
5
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