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CME Eurodollar Futures GH Chicago April 2006

CME Eurodollar Futures GH Chicago April 2006. 3-Dimensional CME Eurodollar Trading. CME Eurodollar futures and options are the “Swiss army knife” of fixed income traders because …

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CME Eurodollar Futures GH Chicago April 2006

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  1. CME Eurodollar Futures GH ChicagoApril 2006

  2. 3-Dimensional CME Eurodollar Trading • CME Eurodollar futures and options are the “Swiss army knife” of fixed income traders because … • They allow one to take advantage of expectations along 3 important dimensions … (1) directional price movements; (2) changing shape of yield curve; and (3) credit risk considerations • This is analogous to options that allow one to speculate on … (1) price; (2) time; and (3) volatility • Use of options on CME Eurodollars futures allow one to express an opinion along several dimensions simultaneously

  3. CME Average Daily Volume Growth by Product Line (round turns in 000’s) Annual Average Daily Volume (round turns, in thousands) 2006 YTD 4,930 19 1980 1985 1990 2000 2005 1975 1995 Interest Rates Equities FX Commodities

  4. ...CME’s Globex Technology: Globex Leads Via Speed Monthly Average Daily Order Volume vs. Average Round Trip Time (RTT) orders (in milliseconds) JAN 04 Jan 06 OCT 04 JUL 05 Oct 05 APR 04 JAN 05 APR 05 JUL 04 Average Daily Order Volume Avg Trade Time

  5. Outline 1. Modeling the probability of FOMC Policy Changes 2. Trading the Curve with Futures and Options 3. Term TED Spreads with Futures and Options

  6. Eurodollar Movements and FOMC Policy • Eurodollars reflect and anticipate target Fed Funds • Futures settled to BBA 3-Month LIBOR … differs from target Fed Funds in terms of credit risk and term

  7. Eurodollar Movements and FOMC Policy • 3-month LIBOR rates anticipate monetary policy shifts

  8. Eurodollar Movements and FOMC Policy Futures have been a good indicator of FOMC policy 19 bip discount of expiring futures to target Fed Funds on 6/16/03 foretold easing on 6/25 During period of policy stability from mid 2003-2004, spread ranged from 10-20 bips Futures traded to premiums in 30-60 bip range by late 2004 as FOMC began to tighten

  9. Eurodollar Movements and FOMC Policy • Recent change in perception from stability (10-20 bips) to tightening (30-60 bip)?

  10. Eurodollar Movements and Fed Policy • THUS … CME Eurodollar futures prices implicitly provide a “best estimate” prediction regarding future Fed policy • March futures premium of 39 bps as of February 15, 2006 implies belief that Fed may tighten 25 by mid March • June premium of 60 bps implies 50-75 bp move between March and May meetings • September premium of 63 bps implies steady rates for June and August meetings

  11. Outline 1. Modeling Probability of FOMC Policy Changes 2. Trading the Curve with Futures and Options 3. Term TED Spreads with Futures and Options

  12. Shape of the Yield Curve • Liquidity hypothesis • S-T securities generally preferred over L-T securities due to superior liquidity • Thus, the yield curve is normally upwardly sloped • Expectations hypothesis • Investors roll from L-T to S-T securities in anticipation of rising rates; or from S-T to L-T in anticipation of falling rates Yields Expected Up: Curve is Steep Yields Expected Down: Curve is Flat or Inverted • Segmentation hypothesis • Investors may be unable to alter portfolio to capitalize on anticipated rate moves because of regulatory constraints, internal policy, asset/liability mix issues, etc. • Introduces otherwise unexplained ‘kinks’ in shape of curve

  13. Deriving Eurodollar Forward Rates Implied forward rates • Eurodollar futures reflect market expectations of forward 3-month rates. An implied forward rate indicates approximately where short-term rates may be expected to be sometime in the future. The following formula provides a guideline for calculating a 3-month rate, three months forward: 1 + 6mth spot rate x 182/360 = (1 + 3mth spot rate x 91/360) x (1 + 3mth fwd rate x 91/360)

  14. Deriving Eurodollar Forward Rates Implied forward rate (IFR) … May be calculated as … d1=90 IFR180,90 d3=180 R90 d2=270 R270 0 90 180 270 Days until Term

  15. Deriving Eurodollar Forward Rates Implied forward rates: Example • 3-month LIBOR spot rate = 5.4400% • 6-month LIBOR spot rate = 5.8763% • 3-month forward rate = R Solve for R: • 1 + .058763 x 182/360 = (1 +.0544 x 91/360)(1 + R x 91/360) • 1.029708 = (1.013751)(1 + R x 91/360) • 1.015740 = (1 + R x 91/360) • 0.062270 or 6.227% = R = the implied forward rate

  16. Speculating on the Shape of the Yield Curve • Use CME Eurodollar futures calendar spreads • Fundamentally … this represents speculation on inflationary expectations expressed in longer-term securities vs. FOMC monetary policy that drives short-end of yield curve • Later, we will extend analysis to use of options

  17. Speculating on the Shape of the Yield Curve • In the second half of 2005, the Fed had raised rates 5 times from 3.00% to 4.25% with L-T rates essentially steady: flattening yield curve • EXAMPLE: Sell the yield curve • On July 1, 2005 … Sell March 2006 and buy March 2007 futures at spread of 0.055% • By December 30, 2005 … spread may have been covered at negative 0.025% for a profit of 8 basis points or $200

  18. Eurodollar Butterfly Spreads Butterfly spreads • Long Butterfly • Buy the nearby wing (1 time) / Sell body (2 times) / Buy the deferred wing (1 time) • Gains if the spread widens or gets more positive (less negative) • Short Butterfly • Sell the nearby wing (1 time) / Buy body (2 times) / Sell the deferred wing (1 time) • Gains if the spread narrows or gets less positive (more negative)

  19. Speculating on the Shape of the Yield Curve • In the second half of 2005, the Fed had raised rates 5 times from 3.00% to 4.25% with L-T rates essentially steady: flattening yield curve • EXAMPLE: Sell the yield curve with the March06, March 07 March 08 Butterfly • On July 1, 2005… sell one March 2006, buy 2 March 2007 and sell one March 2008 at spread of -4.5 bps (-0.045%) • By December 30, 2005 … spread may have been covered at 0.02% for a loss of 2.5 basis points or $62.50

  20. Using the CIX function in BloombergCreating a ED Butterfly Spread

  21. EDH6/EDH7/EDH8 Butterfly

  22. Outline • Modeling Probability of FOMC Policy Changes • Trading the Curve with Futures and Options • Term TED Spreads with Futures and Options

  23. What are “TED” Spreads? • Treasury-EuroDollar • AKA “Swap Spreads” – the difference between an interest rate on a government security (U.S. Treasury note) and an Interest Rate Swap • Originally seen as an indicator of / affected by market’s perception of private sector’s credit quality. • Incidents which received the most coverage: • Continental Illinois Bank crisis (1984) – Treasuries vs. bank deposits • Asian and Russian financial crises (1997-1999) • Housing Agencies (2000) – Changed perceptions on government support • More recently as barometer of pressure from fixed-payers vs. fixed-receivers in interest rate swap market

  24. What are “TED” Spreads? (continued) • Traded by Cash Treasury vs. OTC Swap position • Cash Treasury note vs. Strip of CME Eurodollar futures • Expectation on TED’s Direction: • WIDEN (Buy Treasury / Sell CME Eurodollars) • NARROW(Sell Treasury / Buy CME Eurodollars) • Traded by Cash Treasury vs. OTC Swap position • Cash Treasury note vs. Strip of CME Eurodollar futures • Quick & Dirty TED Spread (CBOT 5-Year Futures vs. individual CME Eurodollar expiration or CME Eurodollar Pack) • Simple to calculate with Bloomberg screen

  25. 5y Swap Spreads and Fed Funds Target Spread in bp 8 NASDAQ bursts GM Downgrades LTCM and Ruble crisis 100 6 4 50 '87 Stock 2 market crash 0 NUGGETTAG:userName=null&plotName=null 1990 1995 2000 2005 USD SWAP 5Y rate (Left) Fed Funds Target (Right) A Look at Credit Events and Spreads Source: LehmLive.com

  26. What are “TED” Spreads? (continued) • 5-year Swap (TED) Spread in Basis Points 2004 WIDENING Employment surprise in Apr leads to more fixed-paying >>> <<<NARROWING Predictions of record budget deficits / more corporate issuance swapped to floating

  27. What are “TED” Spreads? (continued) • 5-year Treasury Yield and 5-Year IRS Rate << Interest Rate Swap << Treasury Yield

  28. Using Bloomberg to find proper hedge • Hedging on the run 5y treasury • GT5 <govt> TED <go>

  29. Quick and Dirty TED Spread Strips … • Presumably, one may trade a CME Eurodollar strip vs. a cash T-Note to create a TED spread • Buy or sell a strip by buying or selling a series of successively deferred CME Eurodollar futures • EXAMPLE: Buy a 1-year strip • But there may be an easier way with use of CME “packs” Buy 3-Month Buy March Buy June Buy Sept Spot Investment Futures Futures Futures 0 90 180 270 360 Days until Term

  30. 1 2 3 4 5 6 7 8 9 10 Quick and Dirty TED Spread Packs and bundles … • Used to facilitate construction and management of strips • A “bundle” represents the purchase or sale of a series of Eurodollars in consecutively deferred months • CME offers 1-, 2-, 3-, 4-, 5-, 6-, 7-, 8-, 9- and 10-year bundles • A “pack” represents the purchase or sale of a series of four (4) consecutively ordered CME Eurodollar futures • Prices quoted by reference to average change in value of all ED futures in pack or bundle since prior settlement • E.g., +2.5 basis points, -6 basis points, … • Prices assigned to individual legs after transaction concluded • Like CME Eurodollar futures, packs and bundles are “color coded” for ease of identification

  31. Quick & Dirty “TED” Spreads • Simplified method for doing term TED spreads using a single CME Eurodollar expiration (or one Eurodollar Pack) vs. CBOT’s 5-Year Note Future • Fourth “Red” (8th Quarterly) CME Eurodollar Future vs. Dec 2005 CBOT 5-Year Note Future • R2 of 0.96 (first difference) EDU7 in October 2005 vs. FVZ4 (8/22/05-10/20/05) • Green (3rd Year) CME Eurodollar Pack vs. Dec 2005 CBOT 5-Year Note Future • R2 of 0.93 (first difference) Green Pack in October 2005 vs. FVZ5 (8/22/05-10/20/05) • Single Eurodollar Expiration (Pack) is surrogate for entire strip of ED expirations & CBOT Note futures are surrogate for cash Treasury note. • Challenge:Find the Hedge Ratio (i.e., basis point value (BPV) of Eurodollar futures position must equal that of CBOT 5-Year futures position)

  32. Quick & Dirty “TED” Spreads (continued) • BPV for CME Eurodollar futures is always $25 per .01 $25 = $1,000,000 x .0001 x 90/360 • BPV for CBOT 6% 5-Year Futures will change with yields • Futures track Cheapest-To-Deliver (CTD) cash Treasury • BPV for CBOT 5-Year futures is cash Treasury BPV divided by CBOT Conversion Factor • For Dec 2005, the CTD was the Treasury 3 1/2% of 02/15/10 • Cash BPV at yield of 4.336% was $38.26 • CBOT 5-Yr future’s BPV was $42.09 ($38.26/.9090 Conversion Factor) • 100 ED contracts have a BPV of $2,500 • Hedge Ratio is 59 CBOT notes to 100 CME Eurodollar contracts • ~59 CBOT Futures = $2,500 / $42.09 • Just the fundamentals---it’s easier with a Bloomberg

  33. Quick & Dirty “TED” Spreads (continued) • Step1: Determine Cheapest-To-Deliver • This will tell you what is C-T-D (it’s the first security) FVZ5 (Commodity) DLV <GO> • Step 2: Determine the value of the C-T-D’s .01 (BPV) • You’ll use “YA” - the Yield Analysis function T 3 1/2 02/10 (Government) YA <GO> • At the bottom of the page you’ll find “DOLLAR VALUE OF AN 0.01” In our case we had $38.26, but your value may be different depending upon rate levels • Step 3: Determine the Hedge Ratio EDU7 (Commodity) FVZ5 (Commodity) PDH2 <GO> • Using the Position Duration Management function (PDH2) is a time saver and allows you to calculate larger or smaller size positions • At the bottom of this page you will see your hedge ratio of 100 CME Eurodollars to 59 CBOT 5-Year notes • On the lower right hand side of the page you’ll see the BPV. This is helpful if you are experimenting with different size positions.

  34. Quick & Dirty “TED” Spreads (continued) • Individual contracts BPV • $2,500 - Eurodollar BPV (100 contracts * $25) • $2,483 – CBOT Note BPV (59 contracts * $42.09) • How is the spread represented graphically? • If you were using the 100:59 ratio one way to look at the spread with aforementioned prevailing prices is as the differential of 3214.5 3214.5 = ((95.57*100) – (107.50*59)) 3214.5 = 9557 – 6342.5

  35. Quick & Dirty “TED” Spreads (continued) • TED (First Red ED/5-year T-Note)vs. 5-Year Swap Spread in Late 2004 << TED Spread Swap Spread CBOT 5-Year T-Note vs. CME First Red ED (Ratio 56:100) Swap Spread>>

  36. Quick & Dirty “TED” Spreads (continued) • Intraday Futures TED Spread Price Movement (EDZ5 vs. EFVZ4) 10/28/04 – 10/29/04 (10-minute Intervals) CBOT 5-Year T-Note vs. CME First Red ED (Ratio 56:100)

  37. Quick & Dirty “TED” Spreads (continued) • TED (Fourth Red ED/5-year T-Note)vs. 5-Year Swap Spread in Summer-Autumn 2005 << TED Spread Swap Spread CBOT 5-Year T-Note vs. CME Fourth Red ED (Ratio 59:100) Swap Spread>>

  38. Quick & Dirty “TED” Spreads (continued) • Intraday Futures TED Spread Price Movement (EDU7 vs. FVZ5) 10/03/05 – 10/04/05 (10-minute Intervals) CBOT 5-Year T-Note vs. CME Fourth Red ED (Ratio 59:100)

  39. Quick & Dirty “TED” Spreads (continued) • “Long” TED Trade Example from Sep 26 – Oct 4, 2005

  40. Quick & Dirty “TED” Spreads (continued) • What about using Eurodollar Packs? • Since Packs are four consecutive quarterly expirations you’d use 25 (still 100 ED contracts) to your 59 CBOT 5-Year Notes • On October 19, the Green Pack settled at 95.25(an average of the EDZ7, EDH8, EDM8, EDU8) • If you were using the 100:59 ratio with the CBOT Note at 106-12+, the value of the spread could be viewed as 3248.0 3248.0 = ((95.25*100) – (106.390625*59)) 3248.0 = 9525 – 6277 • How does the spread look using a Green Pack vs. the Swap Spread?

  41. Quick & Dirty “TED” Spreads (continued) • TED (Green Pack/5-year T-Note)vs. 5-Year Swap Spread << TED Spread Swap Spread CBOT 5-Year T-Note vs. CME Green Pack (Ratio 59:25) Swap Spread>>

  42. Weighted versus Unweighted Strips Unweighted = bundle = zero coupon rate • Easy to calculate • Easy to trade • Equal weight given to each ED futures rate • Shortcoming: TED spread sensitive to yield curve shifts Weighted (BBG “TED”) = coupon rate • Gives greater weight to nearby futures rates, less to deferred rates • More complex to put on and manage • Creates “Pure” credit spread position

  43. Trading the Spread • “Buy” the TED • Buy Treasuries, sell the CME Eurodollar strip • Unweighted (e.g. bundle) • Profits when spread widens • Profits when curve steepens • Increases the relative value of the coupon (treaury) security compared to the unweighted strip • Weighted (BBG “TED” ratios) • Profits when spread widens • Insulated from yield curve changes

  44. Weighted versus Unweighted Strips Upward sloping (steep) Yield Curve: • Unweighted yield is higher than weighted yield • Relatively greater weight given to the higher deferred yields Flat Yield Curve • Weighted/unweighted rates similar • Deferred rates similar to “front” rates Inverted Yield Curve • Unweighted yield lower than weighted yield • Relatively greater weight given to the lower deferred yields

  45. A Convexity Bias Graph

  46. Trading the Spread -Correlation 5-Year Treasury Note vs. 5-Year ED Bundles (6/94-6/99)

  47. Quick & Dirty “TED” Spreads (continued) • Summary: • This is a guide for those who lack ready access to cash Treasury market • Traders will have to watch hedge ratio carefully to adjust it in case of substantial yield changes • The TED spreads they have initiated should be tracked with the help of a spread sheet • Those who spread CME Eurodollars vs. CBOT 5-Year Treasury Notes will receive benefits of cross-margining due to the Common Clearing Agreement between CME and CBOT

  48. Website References and Further Reading Websites • The EOS demo on the web: www.cme.com/options • Real-time prices for electronic Eurodollar futures, calendar spreads, butterflies, packs and bundles and EOS options: www.cme.com/edge • All our brochures, including options brochures are downloadable in .pdf format at www.cme.com Suggested Reading • The Eurodollar Futures and Options Handbook, Galen Burghardt • Options Volatility and Pricing, Sheldon Natenberg. • McMillan On Options, Lawrence McMillan • Options as a Strategic Investment, Lawrence McMillan

  49. CME Eurodollar Futures – An Introduction with Applications This information has been compiled by CME for general purposes only. CME assumes no responsibility for errors or omissions. All matters pertaining to rules and specifications herein are made subject to and are superseded by official CME rules. Current CME rules should be consulted in all cases concerning specifications. For more information on CME products visit us at www.cme.com.

  50. CME Eurodollar Futures GH ChicagoApril 2006

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