PART FOUR
Building Blocks: Eurodollar Options
Calls and puts on Eurodollar futures have provided highly effective tools for trading the yield curve and hedging interest rate and interest rate volatility risk. The Chicago Mercantile Exchange began offering options on Eurodollar futures in 1985. The first options listed for trading were structured so that they expired when their underlying futures contracts expired. They were, as a result, designed to behave like the individual legs of interest rate caps and floors.
Over the years, the CME has filled in the menu of options that can be traded by listing options that expire months or years before their underlying futures contracts expire. One can, for example, trade serial options on a September futures contract that expire in July or August as well as the quarterly option that expires in September. Thus, one can trade 1-month, 2-month, and 3-month options on a rate that is 3 months forward.
Also, one can trade mid-curve options. For example, one can trade options on the Sep ′04 futures contract that expire in September 2002 and September 2003 in addition to the option that expires in September 2004. These mid-curve options have proven especially useful for those who want to take limited risk positions on the level and shape of the forward rate curve and for those who want to hedge convexity exposure and over-the-counter Treasury options.
The material in part 4 is intended for those who know something already about options in general but who want to know about Eurodollar options in particular.1 With this in mind, we will cover:
• Option contract specifications and grid of available options
• Price, volatility, and risk parameter conventions
• Caps, floors, and Eurodollar options
• Structure and patterns of Eurodollar rate volatilities
• Practical considerations
The section on Eurodollar rate volatilities is especially important for Eurodollar option traders because it provides useful insights into the term and maturity structures of volatility and the shapes of distributions of Eurodollar rate changes.