PART THREE
Eurodollar Futures Applications

One of the great advantages of working in a research group at a futures brokerage company is that some really important questions come to you. The chapters in this part are reprints of research notes that report on the results of solving various pricing and hedging questions for our clients. Each has been chosen because it represents an important milestone in our understanding of the way Eurodollar futures should be used in practice.

CONVEXITY BIAS (Chapters 7 through 10)

Anyone who studies finance learns about convexity sooner or later. Even so, it was not until Bill Hoskins and I published “The Convexity Bias in Eurodollar Futures” (chapter 7) that the industry really seemed to sit up and take notice. Until that time, it was standard practice in the swap industry to treat futures rates as if they were forward rates. This practice produced swap rates that were much too high because, as we learned, futures rates should be higher than forward rates. For that matter, at the time we published that note in 1994, the effect of incorporating the value of the convexity bias amounted to almost 6 basis points for a 5-year swap. This was big money and the discovery resulted in a substantial and somewhat painful realignment of futures and swap rates.

Once it became generally well known that the relationship between swap rates and Eurodollar rates was a function of interest rate volatility, a natural extension was to think of the futures/swap spread in option terms. This led us to reporting “convexity bias greeks”—deltas, vegas, and thetas—which we first reported in “Convexity Bias Report Card” (chapter 8).

The steepening of the Eurodollar futures yield curve combined with a sharp inversion of the implied volatility curve for Eurodollar options in 2001 threw a monkey wrench into the way we had been calculating the theoretical value of the convexity bias for more than 5 years. The lessons learned from this episode are reported in “New Convexity Bias Series” (chapter 9), which shows how we dealt with this minor crisis. The solutions reported there were largely the contribution of Lianyan Liu.

Our daily report on the value of the convexity bias has become known as the “Daily Zero to Ten” (chapter 10), which is the successor to what we had called the “Short End.”

TERM TED SPREADS (Chapters 11 and 12)

“Measuring and Trading Term TED Spreads” (chapter 11) was the result of wrestling with the problem of how to map a string of Eurodollar rates into something that could be compared with the yield on a term Treasury note. Measuring TED spreads was no problem when the basic trade was one T-bill contract against one Eurodollar futures contract. But when the industry began to trade 2-year Treasury notes against strips of 8 Eurodollar futures contracts, early efforts to quantify the spread produced wildly different answers. Our work on this note gave us a chance to sort out the real trading questions. At the same time, it allowed us to grapple with a host of real-world hassles that one encounters when dealing with different settlement conventions, day-count conventions, bad dates, and carry. The appendix to this note is especially useful for anyone who has to start coding systems to integrate coupon bonds with Eurodollar futures.

“TED Spreads: An Update” (chapter 12) provides a brief description of our daily “TED Spread” report. One of the great contributions of this report is that it shows forward TED spread values, which represent break-even values given an assumed term repo finance rate.

HEDGING AND TRADING WITH EURODOLLAR STACKS, PACKS, AND BUNDLES (Chapter 13)

We devote a lot of time and attention to deriving what I call “engineered” Eurodollar futures hedges for swaps and coupon bonds. These are the hedges that reflect the true forward rate exposure that you have in a fixed/floating swap or in a coupon bearing note. These are hedges that will work no matter what happens to the level or slope of the Eurodollar rate curve. In practice, though, there are plenty of instances in which the trader or hedger is willing to substitute speed and transactional efficiency for hedge accuracy. Moreover, given the way the structure of Eurodollar futures rates behaves, the idea of using equally weighted strips of Eurodollar futures to hedge or trade makes perfect sense. This chapter is especially useful for getting a working sense of how forward rates behave and an appreciation for just how well the yield behavior of a long-term note can be captured by a comparatively small segment of the futures rate curve.

HEDGING EXTENSION RISK IN CALLABLE AGENCY NOTES (Chapter 14)

The work that went into this note started out as an effort to find an easy and workable futures hedge for the directional exposure in callable bonds. What emerged from this research was that the value of a callable bond depends on the forward value of the note that would be called. This in turn led to our discovery that good directional hedges for callable bonds were sensitive not only to the level of yields but to the slope of the yield curve. And then, when all the dust settled, we concluded that the most efficient futures hedge for callable agency bonds would employ Eurodollar futures. I use this note as the focus of my concluding lecture in my MBA class at the University of Chicago’s Graduate School of Business. It is a perfect vehicle for seeing just why derivatives are so useful to us and why the thinking that is required to understand derivatives helps us to appreciate the real power of Eurodollar futures.

OPPORTUNITIES IN THE S&P 500 CALENDAR ROLL (Chapter 15)

Many of our clients roll positions from one contract month to the next each month or quarter, depending on the expiration cycles. Knowing how best to do these rolls—knowing how to time them in particular—can have a huge effect on the transaction costs incurred in using futures. This note was the result of trying to find the best way of rolling a large S&P 500 futures position. What we found is that the financing rate implied by the S&P 500 calendar spread could be compared directly with the corresponding Eurodollar futures rate, with a comparison of the two providing a reliable guide to the spread’s richness or cheapness.

TRADING THE TURN (Chapters 16 and 17)

By the time this book comes to press, this particular feature of Eurodollar futures may finally have faded into the past. Over 15 years ago, the Federal Reserve completely mismanaged year-end reserves, which led to a huge spike in the Fed funds rate for borrowing that spanned the end of the year. Since that time, from the mid-1980s to the early 2000s, all Eurodollar futures with December expirations traded at noticeably higher rates and lower prices than the normal slope of the curve would suggest. For years, “the turn” was a staple for research and trade recommendations during the months leading up to the end of the year.