Presentation on theme: "What are Eurodollars? Markets developed in London in 1950’s and 60’s"— Presentation transcript:
1CME Eurodollar Futures – An Introduction CME Interest Rate Products October 26, 2005
2What are Eurodollars? Markets developed in London in 1950’s and 60’s Time deposits denominated in U.S. dollars in commercial banks outside the U.S.Benchmark interest rate for corporate funding.Corporations borrow with “floating” rate plus credit spreadAlso known as London Interbank Offered Rate – LIBORSucceeded “Prime Rate” in the late 70’s and early 80’s
3CME Eurodollar Futures CME 3-Month Eurodollar FuturesMost actively traded short-term interest rate contracts in the worldLaunched December 1981On September 15, 2005 open interest in the Eurodollar futures and options contract reached record levels of 29.7 million contractsGrew with development of the interest rate swap market over the last 20+ years
4CME Eurodollar Futures (Continued) CME 3-month Eurodollar Futures (Continued)Most active users:Bank asset/liability managersInterest rate swap dealersLocal traders in ChicagoProprietary tradersHedge fundsNew Developments:Over 80% of Eurodollar futures volume is electronic
5CME Eurodollar Futures Specifications CME Euro$ futures contracts are traded using a price index derived by subtracting the futures’ interest rate from (100- r = Eurodollar Price)Rate represents interest on a 3-month Eurodollar deposit of $1 million.Prices denominated in ¼, ½ or 1 basis point increments (1 basis point = $25)$25 = $1,000,000 x x 90/360Mar, Jun, Sep, Dec contracts listed out 10 years (a total of 40 contracts) including four serial futures (Oct, Nov, Jan, Feb)Futures expire Second London bank business day prior to the third Wednesday of the contract monthFutures are cash settled at expiration to daily British Bankers’ Association survey of 3-month LIBOR
6Eurodollar Mechanics – Outrights, Spreads & Strips Years 1 – 10, quarterlySpreadsSimultaneous purchase and sale of contracts in different monthsSpread traders provide the bulk of liquidity in the front eight Eurodollar contractsStripsThe purchase or sale of two or more consecutive quarterly futures expirations
7Eurodollar Mechanics - Packs & Bundles Packs & Bundles are “pre-packaged” StripsFacilitate rapid execution of specific Strips with a single transactionBundles2-10 year packages of consecutive futures contractsAlways begin with the front quarterly contractQuoted in ¼ basis point (.25) price incrementsPriced on the basis of average net change of each individual contract from previous day’s settlement pricePacks10 specific packages of 4 consecutive futures contractsPriced similarly to BundlesDesignated by color codes that correspond to their position on the yield curve: White, Red, Green, Blue, Gold, Purple, Pink, Silver and Copper12345678910
9Deriving Eurodollar Forward Rates Implied forward ratesEurodollar futures reflect market expectations of forward 3-month rates. An implied forward rate indicates approximately where short-term rates may be expected to be sometime in the future. The following formula provides a guideline for calculating a 3-month rate, three months forward:1 + 6mth spot rate x 182/360 =(1 + 3mth spot rate x 91/360) x (1 + 3mth fwd rate x 91/360)
10Deriving Eurodollar Forward Rates (Continued) Implied forward rates: Example3-month LIBOR spot rate = %6-month LIBOR spot rate = %3-month forward rate = RSolve for R:x 182/360 = ( x 91/360)(1 + R x 91/360)= ( )(1 + R x 91/360)= (1 + R x 91/360)or 4.23% = R = the implied forward rate
12Eurodollar Yield Curve Spreads Calendar or Yield Curve spreads are one of the most common Eurodollar trades at CMESince the value of 1 basis point is $25 in the quarterly Eurodollar futures, the ratios for Yield curve spreads are 1:1Steepening Yield Curve StrategyBuy the shorter maturity Eurodollar Future; sell the longer maturity Eurodollar FutureFlattening Yield Curve StrategySell the shorter maturity Eurodollar Future; buy the longer maturity Eurodollar Future
13Eurodollar Yield Curve Spreads (Continued) Why do you do one versus the other?Steepening Yield Curve StrategyMarket anticipates long-term interest rates will rise faster than short-term interest rates or long-term rates remain steady while short-term rates fall.Reason: General perception is that economy remains weak and the Federal Reserve is expected to do either nothing or to possibly lower interest rates again.Flattening Yield Curve StrategyMarket anticipates short-term interest rates will rise faster than longer-term interest rates.Reason: Employment news surprises market and economy is expected to strengthen further and Federal Reserve is expected to raise short-term interest rates to head off potential rise in inflation.
14Eurodollar Yield Curve Spreads (Continued) Steepening Yield Curve StrategyBuy the shorter maturity Eurodollar Future; sell the longer maturity Eurodollar Future
15Yield Curve Spreads (Continued) Steepening Yield Curve StrategyResults:On 01/30/04, buy 100 of the Mar ’05 Eurodollar futures at ; sell 100 of the Mar ’09 Eurodollar futures at with yield curve spread at 304 basis points.On 03/30/04, sell off 100 of the Mar ’05 Eurodollar futures at ; buy back 100 of the Mar ’09 Eurodollar futures at with the yield curve spread at 326 basis points.Net gain: yield curve steepens 22 basis points for profit of $55,000 (22 b.p. x $25 per b.p. x 100 contracts)
16Eurodollar Yield Curve Spreads (Continued) Flattening Yield Curve StrategySell the shorter maturity Eurodollar Future; buy the longer maturity Eurodollar Future
17Yield Curve Spreads (Continued) Flattening Yield Curve StrategyResults:On 03/31/04, sell 100 of the Mar ’05 Eurodollar futures at ; buy 100 of the Mar ’09 Eurodollar futures at with yield curve spread at 325 basis points.On 06/30/04, buy back 100 of the Mar ’05 Eurodollar futures at ; sell off 100 of the Mar ’09 Eurodollar futures at with the yield curve at 277 basis pointsNet gain: Yield curve flattens 48 basis points for profit of $120,000 (48 b.p. x $25 per b.p. x 100 contracts)
18Yield Curve Spreads (Continued) Federal Reserve tightens on June 30From Mar 31 to Jun 30,Curve has FlattenedRelease of strong March 2004 Employment data on April 2Expect Fed tighteningFrom Jan 30 to Mar 30,Yield Curve has SteepenedSome believeFed might Ease to 0.75%
19Yield Curve Spreads (Continued) False Alarm!Fed tightens for 11th time on Sep 20Fed Funds at 3.75%Mid July - Greenspan says flattening y.c. is not “foolproof indicator of economic weakness”Early June – Greenspan says U.S. economy on “reasonably firm footing”Flattening continuesHurricane KatrinaIs tightening over?
20Eurodollar Butterfly Curve Spreads Butterfly spreads are basically two calendar spreads, back-to-backThey are often executed in this fashion—one spread at a time-or they may be done as a package on GLOBEXRatio is 1:2:1First Wing - 1 contract – first Eurodollar expirationBody - 2 contracts – second Eurodollar expirationSecond Wing - 1 contract – third Eurodollar expiration
21Eurodollar Butterfly Spreads (Continued) Long ButterflyBuy the nearby wing (1 time) / Sell body (2 times) / Buy the deferred wing (1 time)Gains if the spread widens or gets more positive (less negative)Short ButterflySell the nearby wing (1 time) / Buy body (2 times) / Sell the deferred wing (1 time)Gains if the spread narrows or gets less positive (more negative)
22Eurodollar Butterfly Spreads (Continued) Year butterfly spread over time in 2004DateDec PriceDiff.Dec PriceDec PriceButterfly Spread[(EDZ4-EDZ5)-(EDZ5-EDZ6)]Mar 31, 200498.431.2597.180.9496.24b.p.Buy Z4-Z5-Z6 ButterflyJun 30, 200497.481.47+ 0.2296.010.74+ 0.2095.27b.p.Trade Gains 0.42 b.p.;then Sell Z4-Z5-Z6 ButterflySep 20, 200497.790.92+ 0.5596.870.73- 0.0196.14b.p.Trade gains 0.54 b.p.
23Eurodollar Butterfly Spreads (Continued) Year butterfly spread over time in 2005DateDec PriceDiff.Dec 2007 PriceDec PriceButterfly Spread[(EDZ6-EDZ7)-(EDZ7-EDZ8)]Jun 6,95.9350.09595.8400.13095.710b.p.Buy Z6-Z7-Z8 ButterflyAug 9, 200595.3550.085- 0.0195.2700.07595.195b.p.Trade Gains b.p.;then Sell Z6-Z7-Z8 ButterflySep 27, 200595.4950.03095.465+ 0.0196.380b.p.Trade gains b.p.
24Eurodollar Butterfly Spreads (Continued) Butterfly Spreads – Recent History (EDZ6-EDZ7-EDZ8)Mid July - Greenspan says flattening y.c. is not “foolproof indicator of economic weakness”False Alarm!Fed tightens for 11th time on Sep 20Fed Funds at 3.75%Early June – Greenspan says U.S. economy on “reasonably firm footing”Flattening continuesHurricane KatrinaIs tightening over?
25Eurodollar Butterfly Spreads (Continued) Calendar Spreads – Recent History (EDZ6-EDZ8)Mid July - Greenspan says flattening y.c. is not “foolproof indicator of economic weakness”False Alarm!Fed tightens for 11th time on Sep 20Fed Funds at 3.75%Early June – Greenspan says U.S. economy on “reasonably firm footing”Flattening continuesHurricane KatrinaIs tightening over?
28Interest Rate Swap Market Interest rate swap (IRS) transaction …Exchange a series of fixed rate payments for floating rate payments based on a specified amount of principleFixed rate payer “buys” or is “long” … floating rate payer “sells” or is “short” the IRS“Vanilla” swap generally tied to 3- or 6-month LIBOR ratesAn “IMM-dated” swap has floating rate reset dates that match expirations of CME Eurodollar futures but reset dates may be negotiatedThe term or “tenor” of a swap may vary from yearsFixed PaymentsFixed PaymentsFixed Rate PayerFloating Rate PayerDealer@ offer rate@ bid rateFloating PaymentsFloating Payments
29Interest Rate Swap Market Quoting an IRS …Swap generally quoted as fixed rate while floating rate generally tied to 3- or 6-month rate, e.g., LIBORPeriodic payments generally netted$10 mil IRS is quoted at 4.25% vs. flat 6-month LIBOR182 days to 1st payment date when 6-month LIBOR at 3.75%Pricing an IRSFair value of a swap is such that present values of fixed and floating payments are balanced … PVfixed=PVfloatingFixed Payment (Rfixed)=$10,000,000 x x (180/360)$212,500Floating Payment (Rfloating)$10,000,000 x x (182/360)$189,583Net Payment$22,917
30Pricing Swaps with CME Eurodollar Futures Cash flow analysis …Fair value of a swap is such that present values of fixed and floating payments are balanced … PVfixed=PVfloatingConsider IMM-dated swap …WHERE: P = PrinciplePVi = Present value of $1 received i days (di) in futureRi = 3-month LIBOR rate expected to prevail di days in futureSolving for fixed rate Rfixed …nS PVi (Rfixed/4) P i=1=S PVi Ri (di /360) Pi=1Rfixed=n n4 S PVi Ri (di /360) / S PVii= i=1
31Pricing Swaps with CME Eurodollar Futures EXAMPLE: Find value of 2-year $10 mil IRS … Trade date Sep. 19, 2005 for value Sep 21, 2005Fixed rate calculated as % with fixed payment of $107, [=$10,000,000( ¸ 4) ]InstrumentExpiration DateDay SpanPriceYield(R)CompoundValueDiscount Factor (PV)EDU509/19/059396.083.921.01010.9900EDZ512/19/058495.874.131.01990.9805EDH603/13/069895.774.231.03160.9694EDM606/19/069195.724.281.04280.9590EDU609/18/0695.694.311.05410.9487EDZ612/18/0695.664.341.06570.9384EDH703/19/0795.654.351.07740.9282EDM706/18/0795.634.371.08930.9180Rfixed=4 [ (0.9900)(0.0392)(93/360) + (0.9805)(0.0413)(84/360) + (0.9694)(0.0423)(98/360) + (0.9590)(0.0428)(91/360) + (0.9487)(0.0431)(91/360) + (0.9384)(0.0434)(91/360) + (0.9282)(0.0435)(91/360) + (0.9180)(0.0437)(91/360) ] ¸ [ ]4.297% ( %)
32Pricing Swaps with CME Eurodollar Futures Confirm that present values of fixed and floating payments are balanced … PVfixed = PVfloating = $819,877.24Valuation DateFixed PaymentsDiscount Factor (PV)PV of Fixed PaymentsFloating PaymentsPV of FloatingPayments12/21/05$107,425.840.9900$106,348.88$101,266.67$100,251.4503/15/060.9805$105,333.81$96,366.67$94,490.0106/21/060.9694$104,134.70$115,150.00$111,622.2209/20/060.9590$103,020.14$108,188.89$103,751.8912/20/060.9487$101,909.86$108,947.22$103,353.1203/21/070.9384$100,803.98$109,705.56$102,943.1706/20/070.9282$99,707.62$109,958.33$102,058.169/19/070.9180$98,618.24$110,463.89$101,407.21$819,877.24
33Hedging Swaps with CME Eurodollar Futures Matching cash flows …Balance changes in value of hedged item with change in value of futures contractBUT … need to measure changes in value with use of “basis point value” (BPV)BPV measures change in the value of an instrument in response to a one basis point (0.01%) change in yieldBPV of one CME Eurodollar futures (BPVfutures) = $25.00D Value of Hedged Instrument » D Value of Futures PositionBPVfutures=FV x (d/360) x 0.01%$1,000,000 x (90/360) x 0.01%$25.00
34Hedging Swaps with CME Eurodollar Futures Substitute BPV for the abstract concept of change in valueMay be used to find “Hedge Ratio” (HR) or # of futures needed to offset risk associated with spot instrumentEXAMPLE: Find # of CME Eurodollar futures needed to match with $25 million 180-day LIBOR investmentBPV of investment equals $1,250 [=$25,000,000 x (180/360) x 0.01%]Sell 50 CME Eurodollar futures to hedge risk of rising rates and falling valuesBPV » DValueHR=D Value of Hedged Instrument ¸ D Value of FuturesBPVhedged ¸ BPV futures[FV x (d/360) x 0.01%] ¸ $25HR=[$25,000,000 x (180/360) x 0.01%] ¸ $2550 contracts
35Hedging Swaps with CME Eurodollar Futures Hedging cash flows of a swap …PositionRiskHedgeFixed Rate Payer(“Long the Swap”)Rates fall and prices riseBuy CME Eurodollar futuresFloating Rate Payer(“Short the Swap”)Rates rise and prices fallSell CME Eurodollar futures
36Hedging Swaps with CME Eurodollar Futures EXAMPLE: Find BPV of 2-year IMM-dated swap with a $10 million principle amount as discussed aboveCompare original swap value with NPP=$0 to swap value calculated assuming yields advances by 1 basis point (0.01%)Difference in PV of floating and fixed payments changes by $1, [=PVfloating-PVfixed=$821, $819,785.88]PaymentDateFixed PaymentsDiscount Factor (PV)PV of Fixed PaymentsFloating PaymentsPV of FloatingPayments12/21/05$107,425.840.9899$106,346.16$101,266.67*$100,248.8903/15/060.9805$105,328.69$96,600.00$94,714.1906/21/060.9693$104,126.83$115,422.22$111,877.6509/20/060.9589$103,009.78$108,441.67$103,983.8412/20/060.9485$101,897.06$109,200.00$103,579.9103/21/070.9382$100,788.80$109,958.33$103,164.8306/20/070.9280$99,690.11$110,211.11$102,274.819/19/070.9178$98,598.46$110,716.67$101,618.87$819,785.88$821,462.99* First payment in December 2005 is fixed as of date on which the transaction was concluded in September. Thus, there is no change in floating payment and no risk associated with firstset of cash flows.
37Hedging Swaps with CME Eurodollar Futures THUS … the BPV of the swap = $1,677.12Seller of swap (floating rate payer) should hedge risk of rising rates by selling 67 CME Eurodollar futuresBUT … sell which contract month? ANSWER … sell a strip or series of futures matched to each dated cash flowFind BPV for the cash flows associated with 2-year swapMatch PV of payments (PVfixed = PVfloating) on each dateE.g., per original pricing, PVfixed exceeds PVfloating in March 2006 by $10,844 … if rates increase 0.01%, difference becomes $10,614 … resulting in profit for fixed rate payer (“long the swap”) and loss for floating rate payer (“short the swap”) of $229 … floating rate payer might have hedged by selling 9 March 2006 futuresHR=BPVhedged ¸ BPVfutures$1, ¸ $2567
38Hedging Swaps with CME Eurodollar Futures Finding Hedge Ratio (HR) for each payment date …Original ScenarioRates Rise 1 Basis PointPayment Dates(1)PV of Fixed Payments(2)PV of FloatingPayments(3)Float-Fixed(2)-(1)(4)(5)(6)(5)-(4)(7)Diff in Cash Flows(6)-(3)(8)Hedge Ratio(7)¸$2512/21/05$106,348.88$100,251.45-$6,097.43$106,346.16$100,248.89-$6,097.27$0.160.003/15/06$105,333.81$94,490.01-$10,843.81$105,328.69$94,714.19-$10,614.50$229.319.206/21/06$104,134.70$111,622.22$7,487.52$104,126.83$111,877.65$7,750.82$263.3010.509/20/06$103,020.14$103,751.89$731.75$103,009.78$103,983.84$974.07$242.319.712/20/06$101,909.86$103,353.12$1,443.26$101,897.06$103,579.91$1,682.85$239.599.603/21/07$100,803.98$102,943.17$2,139.19$100,788.80$103,164.83$2,376.03$236.849.506/20/07$99,707.62$102,058.16$2,350.54$99,690.11$102,274.81$2,584.70$234.169.49/19/07$98,618.24$101,407.21$2,788.97$98,598.46$101,618.87$3,020.41$231.459.3$819,877.24$0$819,785.88$821,462.99$1,677.1267.1
39Hedging Swaps with CME Eurodollar Futures THUS, appropriate hedge is to sell 67 futures …Hedge is “self liquidating” as futures contracts will settle in cash as each payment/expiration date passes bySell9March 2006CME Eurodollar futures11June 200610September 2006December 2006March 2007June 2007September 2007