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Eurodollar Futures: Rate, Yield And PriceStructures

PAUL D. CRETIEN

Eurodollar futures contracts are priced as 100 m inus the 90-day interest rate on dollar-denominated deposits in non-U.S. banks . Because of their ease of trading, liquidity and usefulness in hedging interest rate movements, eurodollarfutures with contracts priced over a 10 -year s pan for 40 future quarters exhibit their highest trading volume overthe first 20 quarters or five-year maturities. Regardless of the diminis hed volume of trading on the rem aining 20quarters, the entire set of 40 quarterly contracts is continuously synchronized with corresponding quarterly U.S.Treasury yields .

Eurodollar futures yields shows the curve of quarterly interest rates calculated as 100 m inus the price for each of 40quarterly futures on Jan. 25, 2010. The quarterly rates are us ed to create a chain of quarterly yields in which eachquarters yield is the geom etric mean of rates to that point. The close relationship between eurodollar quarterly yields

and U.S. Treasury yields at the s ame m aturities is s hown by comparison with eight Treasury yields extending fromthree-month to 10-year maturity. Interest rate arbitrage binds eurodollar futures, T-note futures and U.S. Treasury incomm on price and yield relationships. Four of these relationships, or structures, warrant a deeper look.

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Market relationships

Structure #1 is the eurodollar yield curve in correspondence with the U.S. Treasury yield curve. The structure isuseful primarily in spread trades between eurodollar futures at the 20 -quarter maturity and five-year T-note futurescontracts. The s tructure is hidden because it mus t be calculated from lis ted eurodollar prices and quarterly rates, butonce exposed, it is a dependable aide in trading eurodollar/T-note futures price and rate spreads. Eurodollar yieldsthat are more that five bas is points more than, or less than, the yield on five-year T-note futures indicate the

possibility of a spread trade. Eurodollar quarterly rates must adjust the eurodollar/T-note spread, causing theeurodollar prices to move in the oppos ite direction.

It may be noted that U.S. Treasury yields also have a hidden structure the quarterly rates that the market implicitlyuses to derive the listed yields to maturity. Considering that the yields to maturity for each Treasury securityeffectively resul t from the geometric means of invisib le quarterly rates, the eurodollar quarterly rates show theunderlying structure of U.S. Treasury yields with a parallel adjustment for the additional risk and lack of convexityof eurodollar futures.

Structure #2 is the curve of ratios between eurodollar quarterly rates and yields. As shown in Ratios of eurodollarrates-to-yields, (right), Structure #2 on Jan. 25, 2010, peaked at approximately eight quarters with a ratio of 1.90.Structure #2 is intrinsically tied to Structure #1 because eurodollar quarterly rates are forced to rise quickly, so thatthe resulting geometric mean yields that average the chain of preceding yields m ay remain parallel and in closeproximity to the corresponding U.S. Treasury yields.

The second structure of eurodollar futures is subject to Federal Reserve policy. While the Fed works to s tabilize theU.S. econom y, rates and yields on eurodollar futures and Treasury securities currently start near zero for the shortestmaturities. Structure #2 reflects that, relative to its beginning at or near a zero yield, the Treasury yield curve has asignificant upslope over the 10-year m aturity, although U.S. interest rates seem historically low at the present time.Future changes in the shape of Structure #2 will depend on how quickly short-term Treasury yields rise in res ponse to

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increases in long-term yields .

Structure #3 is the interplay between December eurodollar futures and the following March futures from the 12thquarter through 40th quarter maturity. Eurodollar futures seasonality shows that the ratio of change in rates betweenquarters has Decem ber high and March low in a pattern that holds over time. Although the underlying concepts arefundamentally different, it is tempting to compare the seasonal variations of eurodollar futures with a s tanding wavein physics or harmonics in music wave patterns that are predictable and continuous as long as the underlyingconditions persist.

Because the Decem ber-to-March waves occur primarily in the maturities that have relatively low trading volume, thechart pattern may be the result of ass umptions built into computer pricing and trading systems. The curve ofeurodollar rates that appears sm ooth on Eurodollar futures yields disguises hidden Structure #3 with its quarterlywaves.