The Eurodollar Spread
By Aaron Fennell ISSUE 811 | November 2009
The Eurodollar futures market is one of the most liquid and important markets in the world. It provides a valuable, cost-effective tool for hedging interest rate fluctuations on Eurodollars – U.S. dollars deposited in commercial banks outside the United States. Eurodollar futures contracts are traded at CME Group, and track the very low-risk U.S. dollar interbank lending rates. These interest rates underpin the financing of almost all U.S. dollar lending and asset valuation. Other interest rates are priced in comparison to these rates, based on relative risk. Large volumes of trading occur through the Eurodollar futures market for the purpose of interest rate hedging.
The term structure of Eurodollar futures essentially matches the yield curve of the interbank lending market. Imagine that Eurodollar futures simply represent the yield curve sliced into three-month pieces. The quarterly contracts can be combined in an endless number of ways to create a synthetic interest rate structure. For example, the implied interest rate in a strip of Eurodollar futures will be similar to the interest rate reflected in an interbank instrument of similar term.
Implied Bid/Offer Spreads
The CME Globex platform has the capacity to handle what is referred to as “implied spreads,” which is critical for the strategy. Globex considers the bid/offer for spread orders in quoting the bid/offer for outright orders, and vice versa. For example, the bid/offer for the outright December 2011 Eurodollar contract and the bid/offer for the December 2011/December 2012 Eurodollar spread would be combined to reflect an implied bid/offer for outright December 2012 Eurodollars.
During the era of pit trading, floor traders provided this function by continuously comparing the relative prices for each contact month. If a single contact month was pushed out of alignment because of significant buying or selling pressure, traders would transfer liquidity from other contact months through the use of spread trades. Floor traders made a living off of knowing the normal relationships between the various contract months of the same underlying commodity, and provided liquidity in exchange for the opportunity to profit. The technology offered by the CME Globex platform simply automates this process, making it possible for off-the-floor traders to perform similar trades. This technology is outlined more completely in a presentation through the following link.
http://progressive.powerstream.net/008/00102/edu/impliedpricefunctionality/player.html
Yield Curve
The textbook yield curve tends to be upward sloping and is usually steeper in the shorter term. That said, it is not uncommon for the yield curve to become inverted or twisted, particularly in the shorter term. The Eurodollar contracts that expire within a few years trade almost directly off the expectations of FOMC interest rate targets, which can change dramatically with little warning. It is not uncommon to see year-over-year spreads of positive 100 basis points or negative 50 basis points for contracts within three years of expiry. Alternatively, the long-term portion of the yield curve tends to be much flatter. Further out on the yield curve, its shape has much more to do with the supply and demand expectations for long-term debt, so the relationship between various long-term rates is much tighter.
For example, the difference between a two- and three-year interest rate is more volatile than the difference between a seven- and eight-year interest rate. Therefore, risk and relative value of spreads on longer-dated Eurodollar futures can be more easily measured and managed. The chart below illustrates the year-over-year spreads for the Eurodollar futures.
Trading Strategy
The first question that comes to mind when looking at a strategy that works is to ask why others aren’t doing the same thing. The simplest answer to this question is that others are in fact trading this strategy, but spread trading is still a small part of the broader marketplace. Spread trading provides liquidity to the marketplace and greater liquidity attracts an ever-greater amount of outright trading. Providing liquidity to the marketplace is a service that should yield an economic profit.
The profitability and risk for each spread is small relative to the magnitude of the total position. When large orders are placed in the debt markets, interest rates are pushed only slightly in one direction or the other. This causes the spreads to swing back and forth by a few points and then snap back to their fair value. Further, there are medium-term swings that cause the spreads to expand and contact like a tide. Traders can trade these spreads within some measure of outside bounds. Each Eurodollar spread has a notional value of $1,000,000, with a margin requirement of only $250 per spread. Low margin rates permit a tremendous amount of leverage that magnify both the profitability and risk from these very small inefficiencies.
In very broad terms, the mechanics of the strategy can be summarized.
- Select a particular year-over-year spread that has at least six years to expiry before the nearer month expires.
- Estimate a long-term pricing mid-point for the spread. When the spread is below the midpoint, establish long positions at regular increments.
- When a position is established, place a liquidating order with a pre-specified amount of profit. Within the expected trading range traders would ladder into the positions at regular increments in line with available margin. Alternatively when the spread climbs to the higher portion of the normal range, one can sell the spreads using the opposite pattern.
- As the spread oscillates, you are either adding positions or liquidating positions. The key is to calculate the possible outer bounds of the spread and have sufficient margin to cover all the positions, so as not to over- leverage (too many positions for the size of the account) when the spread is at its most extreme point.
As with any complex strategy, there are usually a range of questions that need to be asked. Therefore, it is important to work with an advisor who understands and can explain the intricacies of the strategy. If you are interested facilitating such a strategy or have other questions about the markets, you are welcome to give me a call.
Aaron Fennell is a Senior Market Strategist based in Toronto with Lind-Waldock, a division of MF Global Canada Co. He is accepting clients in Canada and can be reached at 416-369-7933 or 877-840-5333 or via email at afennell@lind-waldock.com.
Kristina Zurla Landgraf is editor of Lind eWire. She can be reached at editor@lind-waldock.com.
Futures trading involves substantial risk of loss and is not suitable for all investors.
Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
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