GLOSSARY1
ATM At-the-money option. An option is at the money when its strike price is equal to the futures price.
BBA British Bankers’ Association. The Chicago Mercantile Exchange uses the BBA’s 11 a.m. 3-month LIBOR fixing as the final settlement rate for the Eurodollar futures contract. See BBAISR.
BBAISR British Bankers’ Association Interest Settlement Rate.
BBA 3-month LIBOR is “fixed” daily at 11 a.m. London time. The BBA surveys 16 banks and asks them to quote the rate at which they would lend to major participants in the London Eurodollar market. The BBA eliminates the top and bottom quartiles from the survey and averages the remaining quotes. The fixing is rounded up to 5 decimal places when the sixth digit is 5 or greater.
For purposes of settling the Eurodollar futures contract, the British Bankers’ Association Interest Settlement Rate (BBAISR) is taken on the second London bank business day immediately preceding the third Wednesday of the contract month. This value is rounded to the nearest 1/10,000 of a percentage point and subtracted from 100 to determine the Eurodollar futures contract final settlement price.
bey Bond Equivalent Yield.
bp Basis point, 0.01%, or 1/100 of a percentage point.
break-even volatility The value of realized volatility at which the cost of paying a long option’s theta is just offset by the beneficial effects of gamma combined with the realized change in the option’s underlying price or rate. See any good options textbook for a derivation of the “zero profit” condition, holding implied volatility constant.
bundles A 1-, 2-, 3-, 4-, 5-, 6-, 7-, 8-, 9-, or 10-year strip of quarterly cycle Eurodollar futures. A bundle usually begins with the first quarterly contract, but there is also a 5-year bundle 5 years forward.
cabinet trade A trade that allows the liquidation of deep-out-of-the-money options at the “cabinet” or “cab” price. The cabinet price for Eurodollar options is one-quarter tick, or $6.25.
calendar spread A calendar spread comprises a long (or short) position in one contract month and a short (or long) position in a subsequent contract month. Eurodollar futures calendar spreads are used to trade the yield curve. Eurodollar option calendar spreads are used to trade the volatility curve or to take advantage of differences in the gamma, theta, and vega characteristics of options with different times to expiration.
CME Chicago Mercantile Exchange.
cones See volatility cones.
correlation A statistical measure of how two variables vary together. When squared, correlation is the fraction of the variance of one variable that can be explained using information about the value of one or more other variables. A negative correlation indicates that the variables change in opposite directions, while a positive correlation indicates that they change in the same direction. Correlations of −1 and 1 describe two variables that are perfectly correlated and for which, knowing the value of one of the variables, one can explain entirely the value of the other. A correlation of 0 indicates no relationship at all. A correlation of 0.5 indicates that 0.25 [= 0.52], or 25 percent, of the variance of one variable can be explained using the values of the other.
coupon yield curve A curve that plots the values of coupons at which coupon-bearing bonds would trade at par against their respective times to maturity.
CPI Consumer Price Index.
credit spread A measure of the basis point yield spread between a risk-free instrument (i.e., Treasury bills, notes, or bonds) and another instrument.
day-count convention The convention used to calculate the fraction of a year applied to an interest rate calculation. The money market convention is days/360 for the following currencies: U.S. dollar, Euros (€), Japanese yen, and Swiss franc. The money market convention is days/365 for the British pound and Canadian dollar. Other day-count conventions, used in swap interest rate calculations for example, include Act/Act, Act/365, Act/365 (fixed), 30/360, 360/360, Bond Basis, and 30E/360.
delta The change in an option’s price given a small 1-unit change in the price of the underlying commodity or futures contract.
duration Duration is a weighted average of the times to a bond or note’s cash flows. The weights used in calculating duration are the fraction of the bond’s total present value represented by each cash flow.
Modified (or effective) duration typically is defined as the percent change in the full price (i.e., quoted price plus accrued interest) of a bond or note given a 1-percentage-point change in its yield. With a bond that bears regular coupons, the relationship between modified duration and duration is Modified duration = Duration/(1 + y/n), where y is the bond’s yield and n is the number of times per year the coupon is paid.
For instruments without regular coupon or principal payments, or for instruments that contain embedded options, the instrument’s “effective duration” refers to the percent change in its value given a 1-percentage-point change in its underlying yield. Effective duration makes more sense when discussing Eurodollar futures.
DV01 The dollar value of an “oh-one,” or 1-basis-point change in any relevant interest rate. Also known as the DVBP, or dollar value of a basis point. DV01 can represent the change in the (present) value of a bond or swap position given a 1-basis-point change in its yield or some underlying rate. DV01 also can represent the change in any cash flow related to the underlying rate.
e Exponential. Commonly used to calculate future value (i.e., e rt) and present value (i.e., e−rt), where r is a continuously compounded annualized interest rate and t is the number of years in the period.
EBF European Bankers Federation.
ED The trading symbol for Eurodollar futures at the Chicago Mercantile Exchange.
edge The theoretical price of an option versus the market price of an option.
Euribor futures Three-month Euro (€) interest rate futures. This 3-month deposit contract is based on €1,000,000 and has a final settlement price that settles to 100 − 3-month Euribor.
Eurodollar time deposit A dollar deposit with a bank or bank branch outside of the United States or with an international banking facility located in the United States.
expiration date For Eurodollar futures and quarterly options, the second London business day immediately preceding the third Wednesday of the contract month. For serial options, mid-curve options, and 5-year bundle options, the Friday preceding the third Wednesday of the contract month.
expiring contract The futures contract that will expire next.
fair value The fair value of a Eurodollar futures contract is 100 less the fair value of forward 3-month LIBOR with a value date equal to the value date of the futures contract. The fair value of a contract is compared to its traded value to determine if the contract is rich or cheap.
FOMC Federal Open Market Committee.
forward deposit rate The rate associated with a deposit period that begins sometime in the future.
forward term deposit curve Same as a term deposit curve except that the terms begin at some date in the future.
forward yield curve Any yield curve for which time begins at some date in the future.
FRA Forward Rate Agreement. An over-the-counter instrument that is used to lock in a forward-starting short-term interest rate. For example, a 1 × 4 FRA represents a 3-month forward rate (i.e., 4 minus 1) that begins 1 month from now. The difference between the FRA rate and the prevailing market rate at the start of the FRA determines the net cash flow to one of the counterparties.
front month contract The contract in the quarterly cycle that is nearest expiration.
gamma The change in an option’s delta given a small 1-unit change in the price of the underlying commodity or futures contract.
GLOBEX The Chicago Mercantile Exchange’s electronic trading platform.
historical volatility Any measure of volatility that has been estimated using historical prices or interest rates. Historical volatility typically is calculated as a standard deviation of price or rate changes and is a measure of how volatile the underlying price or rate has been in the past.
IMM swap A type of swap with reset dates that fall on Eurodollar futures expiration dates and with payment dates that fall approximately 3 months later on the following Eurodollar futures value dates.
implied volatility The value of volatility that sets an option’s theoretical price equal to its market price. As such, implied volatility is implied both by the market price of the option and by the theoretical model used. Implied volatility can be thought of as a market forecast of how volatile the underlying price or rate will be over the remaining life of the option.
initial peformance bond The minimum performance bond deposit required from customers for each contract when a futures position is opened.
interest rate swap An agreement under which the two sides to the transaction agree to exchange cash based on hypothetical interest calculations. The most commonly traded swap is a fixed/floating swap under which one side agrees to pay a fixed rate on a specified notional principal amount, while the other side agrees to pay a floating rate on the same notional amount.
ITM In-the-money option. A call is in the money when its strike price is less than the futures price. A put is in the money when its strike price is greater than the futures price.
kurtosis One measure of the shape of the distribution relative to the normal distribution. The kurtosis of the normal distribution is 3.00. Positive excess kurtosis is the value of a distribution’s kurtosis that exceeds 3.00 and describes a distribution with fat tails and a tightly bunched center.
lead contract The most active futures contract. The lead contract is designated by where it trades on the floor of the Chicago Mercantile Exchange. The lead contract may or may not be the same as the expiring contract.
LIBID London Interbank Bid Rate. The rate that the most creditworthy international banks dealing in Eurodollars pay for deposits.
LIBOR London Interbank Offered Rate. The rate that the most creditworthy international banks dealing in Eurodollars charge each other for large loans.
LIFFE London International Financial Futures and Options Exchange.
Ln The natural log mathematical function.
maintenance margin See maintenance performance bond.
maintenance performance bond A sum, usually smaller than the initial performance bond, which must remain on deposit in the customer’s account for any position. Previously referred to as maintenance margin.
mark to market Marking a position to market requires valuing all positions, and hence all gains and losses, at market prices. Can also refer to the daily adjustment of the performance bond account to reflect gains and losses.
mid-curve options Quarterly 1-year mid-curve options expire 12 months before their underlying futures contract. For 1-year mid-curve options that expire in months other than those in the March quarterly cycle (i.e., January, February, April, May, July, August, October, and November), the underlying futures contract is the futures contract that expires 12 calendar months from the next March quarterly month that is nearest to the expiration of the option. For example, the underlying futures contract for the 1-year mid-curve option that expires in January or February is the March futures contract in the next calendar year.
For 2-year mid-curve options, the underlying futures contract is the contract that expires 24 calendar months after the month in which the option expires.
money market instrument Any of a number of short-term interest rate instruments, including bank deposits, commercial paper, and bankers acceptances.
MOS Mutual Offset System. The Eurodollar futures contracts traded at the Chicago Mercantile Exchange and the Singapore Exchange are considered fungible instruments. The two exchanges use the Mutual Offset System to allow Eurodollar futures contracts traded at one exchange to offset Eurodollar futures contracts traded at the other exchange. Also, open positions at one exchange can be transferred to the other exchange.
NAPM National Association of Purchasing Management.
Nominal value of an 01 See DV01. Usually refers to the actual change in a forward cash flow.
on the run See OTR.
open interest The total number of contracts outstanding that have not yet been offset or have not yet expired.
OTC Over the counter. An instrument that is traded directly between two counterparties rather than on an exchange.
OTM Out-of-the-money option. A call is out of the money when its strike price is greater than the futures price. A put is out of the money when its strike price is less than the futures price.
OTR On the run. The Treasury’s most recently issued note/bond for a given maturity. The on-the-run issues tend to be the most liquid.
over the counter See OTC.
packs A series of 4 quarterly cycle Eurodollar futures contracts. The packs trade according to the color-coded grid developed by the Chicago Mercantile Exchange. The “whites” are the first pack to trade, followed by the “reds,” “greens,” “blues,” and so on. Packs can begin with any specified contract month, e.g., 2nd red would refer to a 4-contract strip beginning with the 6th quarterly Eurodollar contract.
performance bond Funds that must be deposited by a customer with his or her broker; by a broker with a clearing member; or by a clearing member with the Clearing House. The performance bond helps to ensure the financial integrity of brokers, clearing members, and the Exchange as a whole. Previously referred to as margin.
PV01 The present (or price) value of a 1-basis-point change in rates. To convert the nominal value of a basis point to a PV01, multiply the change in cash flow by the price of a zero-coupon bond that matures on the forward cash flow date.
quarterly contracts Contract months with expirations in March, June, September, and December.
R2 R-squared. In a regression of one variable (y) on one or more other variables (x), the R2 of the regression is the fraction of the variance of y (the dependent variable) that can be explained using one or more x (independent) variables. R2 values range from 0 to 1.
realized volatility Calculated the same way as historical volatility but with a starting date equal to an option’s trade date. Realized volatility is a measure of how volatile the market proves to be during the time following an option trade and can be compared with the option’s initial implied volatility to determine the potential ex post profitability of the trade.
Rulebook The Chicago Mercantile Exchange Rulebook is a complex document that covers all aspects of trading, settlement, performance bonds, etc. For the most recent version of the Rulebook, go to www.cme.com.
semiannual bond equivalent yield (SA BEY) The standard yield quote for U.S. Treasury bonds and notes.
serial contracts Contract months with expirations outside of the quarterly cycle. Serial futures and options contracts expire in January, February, April, May, July, August, October, and November.
serial options Option contract months with expirations outside of the quarterly cycle. Serial contract months expire in January, February, April, May, July, August, October, and November. Serial options are on the next following quarterly futures contract (e.g., the July option on the September futures).
settlement date In the Eurodollar time deposit market, the date on which interest begins accruing. The standard settlement period is two London business days for all terms except overnight (O/N) and tomorrow next (T/N), which settle same day and next day, respectively.
SGX Singapore Exchange (formerly the Singapore International Monetary Exchange, SIMEX).
spot deposit rate See term deposit rate.
stacks A technique used in the Eurodollar futures market where a single contract is executed in place of a series of contracts along the yield curve. The benefits of trading a stack are liquidity and ease of execution.
standard deviation A statistical measure of the spread of any distribution of a random variable. For the normal distribution, a range of 1 standard deviation above and below the mean includes about 68 percent of the outcomes; 2 standard deviations up and down captures about 95 percent of the outcomes; and 3 standard deviations includes about 99.7 percent of the outcomes.
In options markets, volatility is expressed as an annualized standard deviation of changes in the underlying price or rate.
straddles Long straddle: Long a call option and long a put option at the same strike price and with the same time to expiration. A long straddle is a volatility trade that profits, if delta neutral, when realized volatility exceeds implied or expected volatility. A short straddle tends to make money when the underlying market is less volatile than expected by option traders.
strangles Long strangle: Usually long an out-of-the money call and long an out-of the money put with the same time to expiration. Because the options are out of the money, the price of a strangle is less than the price of a straddle. Strangles often are used by traders who think that the underlying price will settle within the two strike prices (in which case they sell the strangles) or will settle outside of the two strike prices (those who are long the strangles).
stub rate The term deposit rate that runs from today until the first Eurodollar futures value date.
swaption An option on a fixed/floating interest rate swap with a specified fixed rate that begins on a specified forward date.
TED spread The spread between Treasury and Eurodollar rates. The TED spread is a measure of the credit spread between LIBOR (i.e., high-grade bank debt) and Treasury debt. The original TED was the price spread between 3-month T-bill futures and Eurodollar futures, which would equal the difference between the implied Eurodollar and Treasury bill futures rates.
term deposit curve A curve that plots term deposit yields against time to maturity.
term deposit rate In the LIBOR market, deposit rates for terms that range from overnight to 10 years. With the exception of overnight (O/N) and tomorrow next (T/N), the value date for term deposits is 2 (London) business days from the transaction date. Also known as spot deposit rate.
term structure of deposit rates A graph or table of spot deposit rates versus maturity of deposit. The graph of this data produces a yield curve.
term structure of volatility A graph or table of volatilities versus maturity of instrument.
term TED spread The spread between the rates implied by a strip of Eurodollar futures and the yield on a Treasury note.
terminal wealth The value to which one dollar invested today, at a defined sequence of rates and with a complete reinvestment of periodic principal and interest, will grow as of a given date in the future. Terminal wealth can be calculated from a stub rate and consecutive Eurodollar futures rates. The inverse of terminal wealth is the zero-coupon price, or present value, of $1 to be received on the terminal wealth date.
theta The change in the option price given the passing of 1 day.
value date The value date for a Eurodollar futures contract is 2 London business days following its expiration date. In other words, the value date is the third Wednesday of the contract month.
variation margin Describes the cash that is paid into or out of an account to reflect changes in the market value of the position.
vega The change in the option price given a 1-percentage-point increase in the option’s implied volatility.
vega-weighted spread trade An option volatility spread trade that is structured so that the long and short options provide equal but offsetting vegas. This ensures that the trade returns the same profit (or loss) if the volatility spread changes, regardless of whether volatilities rise or fall.
volatility A measurement of the variability, usually expressed as a standard deviation, of the underlying Eurodollar futures rate. Volatility is usually measured as a relative rate volatility (i.e., a change in the rate as a percent of the underlying rate), but can be measured in actual, or basis point, rate changes. Volatility can be historical, implied, or realized.
volatility cone A graphical representation of the maximum and minimum n- period historical volatilities estimated over any given history of prices or interest rates. Especially useful for gauging the richness or cheapness of options with different remaining times to expiration.
volume (of trading) The total number of contracts traded during any given trading period.
yield to maturity The internal rate of return that sets the present value of a bond’s cash flows (i.e., coupon and principal payments) equal to its full price.
zero-coupon bond A bond that bears no coupons. Its price is less than 100 before maturity and 100 at maturity.
zero-coupon price The present value of one dollar for the stated term. A forward cash flow multiplied by the associated zero-coupon price gives the cash flow’s present value.
zero-coupon yield curve A curve that plots yields from zero-coupon bonds versus time to maturity.
The shortest end of a dollar-based zero-coupon curve might be calculated from Eurodollar term deposit rates; the middle of the curve from Eurodollar futures rates; and the long end of the curve from interest rate swap rates. When properly constructed, zero-coupon yield curves can be used to calculate the present value of any cash flow on any date and to calculate forward interest rates between any two forward dates. Zero-coupon yield curves are the most basic building blocks for financial engineers.