PART FIVE
Eurodollar Option Applications

This section provides three research notes that deal with aspects of trading or hedging with Eurodollar options.

TRADING WITH SERIAL AND MID-CURVE EURODOLLAR OPTIONS (Chapters 23 and 24)

The first note, “Trading with Serial and Mid-Curve Eurodollar Options” (chapter 23), is a guide to the rich variety of trading opportunities that opened up when the Chicago Mercantile Exchange decided to list short-dated options on longer-dated Eurodollar contracts. Serial and mid-curve options are really the same thing but with different horizons. In both cases, the option expires before the underlying futures contract. Thus, it is possible to trade options that expire in 1, 2, or 3 months on futures that expire 1 or 2 years later. These options make it possible to hedge or spread against over-the-counter Treasury options. They also open up the possibility of using options to trade the slope and shape of the futures rate curve.

WHAT HAPPENS TO EURODOLLAR VOLATILITY WHEN RATES FALL? (Chapters 25 and 26)

The research note “What Happens to Eurodollar Volatility When Rates Fall?” (chapter 25) was the result of watching implied Eurodollar rate volatilities skyrocket when Eurodollar futures rates fell dramatically in 2000 and 2001. At issue here is the question of whether basis point volatility or relative rate volatility is more stable. One of the really interesting conclusions of this note is that there has been no obvious relationship between basis point volatility and the level of rates. That is, it seems as if the standard deviation of futures rate changes, when expressed in basis points, was just as high when rates were 2 percent as when rates were 8 percent. As a result, all of our ideas of the richness and cheapness of Eurodollar options, when based on implied relative rate volatilities, were useless. This led us to revise our volatility cones to show historical and implied basis point volatilities for Eurodollar options. An example of our new report is provided in “Eurodollar Volatility: An Update” (chapter 26), which compares volatility cones for relative and basis point rate volatility.

HEDGING CONVEXITY BIAS (Chapter 27)

The final chapter is “Hedging Convexity Bias” (chapter 27), whose purpose was to find a workable Eurodollar options hedge for the volatility exposure that swap dealers have when they hedge their swap book with Eurodollar futures. This challenge posed two problems. For one, swap traders with Eurodollar futures hedges are worried about rate volatilities for horizons up to 5 or 10 years, while most Eurodollar options expire within 2 years. For another, the “greeks” of the two positions respond differently to a change in the horizon. The gamma of a conventional option decreases with time to expiration while the “gamma” of a swap/futures position increases with the maturity of the swap. This note presents, however, a workable and inexpensive hedge solution that swap traders can use to protect themselves against losses when implied volatilities are high and are threatening to fall.