Eurodollar term structure

Posted: February 7, 2010 in Uncategorized

What is term structure?

It is the multiple contracts at different time (or price for options) expirations on the same underlying instrument.  For this example, we will focus on CME listed Eurodollars.  Eurodollars represent a time deposit on $1,000,000 with a 3 month maturity (there are also 30 expirations but we aren’t speaking of those here); for more information see http://www.cmegroup.com/trading/interest-rates/stir/eurodollar_contract_specifications.html.  The 3 month expirations refer to quarters of a year (March (futures symbol:H), June (M), September (U), December (Z))

How are they priced?

Quoted in IMM Three-Month LIBOR index points or 100 minus the rate on an annual basis over a 360 day year.

Ready. Set. Go.

Taking 3 months of historical market data, we will compute correlations, standard deviations, and covariance of the market data.

Here we see the correlation:



But wait, what is this W1, W2 stuff?  Ooops, I forgot to mention that eurodollar traders refer to the contracts in color codes that mimic the colors on old 1980’s television sets!  They are White, Red, Green, Blue, Gold, Purple, Orange, Pink, Silver, and Copper.  Each refers to a specific year of the curve; for instance R1 refers to the March 2011 expiration since the first white expiration is currently March 2010.  Every expiration is always relative to the current front month (leading contract).

By inspection, the term structure is as one would expect to be, that is highly correlated in at shorter expirations where the rates are likely to remain low from current Federal policy and lower in the back end as the price uncertainty is higher due to lack of knowledge when Federal liquidity programs will end.

But what types of moves are there in the market?

The above graph shows the standard deviation of returns in the eurodollar market and the movement is shown in basis points.  Again, this shows the expectation of price in the front contracts is perceived to be better known than the back end of the term structure.

Can we put these together to get a big picture?

Sure, we call this statistical property covariance.  Wait but what is covariance!  Covariance is a statistical measure of how much 2 or more variables change together.

So action is prone to occur in the 4th white or 1 red then predicate the movement of the entire term structure?  More than likely.

Is there any way that we might be able to trade this in some fashion that reduces the risk of such massive term structure moves?  Sure, there are a number of ways to do this.  The CME actually has several listed strategies that may help you do just that!  What are exchange listed strategies? They are listed spreads of 2 or more instruments with no execution risk that you incur with spreaders.  Wait but what is a spreader? A spreader is a tool that works 2 or more outright instruments to create a synthetic position with ideal characteristics for your trading methods.  Ok, but what are strategies again and can I get some examples?

Sure.  Here are some examples:

Spread: W1-W2, Long/Short, each of different expirations.  We would call this long the spread.  Conversely, if you were short W1 and long W2 you would be short the spread.

Butterfly: W1-2*W2+W3, Long/2*Short/Long each of sequential expirations.  There are broken butterflies in the agriculture futures market but we won’t consider those here.

Double butterfly: Long W1 butterfly/Short W2 butterfly.  Again, different expirations.

Packs:  Now this is an interesting creature in that it is long 1 contact of a particular color code (remember the color TV scheme above!).  For instance, if you bought the white pack then you get a long position in H0,M0,U0, and Z0.  These are quoted in net change on the day from the previous day’s settlements.

Bundles:  Now this is even weirder!  This creature gives you a position in each contract by the number of years covered from 1-10 years out.  For instance, buying a 2 year bundle would give you a long position in H0,M0,U0,Z0,H1,M1,U1, and Z1.  This as well is quoted in net change from yesterday’s settlement.

Wow, that was alot to take in!  Now what can I trade with this to make money?  Treasury – Eurodollar spreads, Swaps – eurodollars, eurodollar options, Agency notes to eurodollars, etc.  Eurodollars are the building blocks for most short-term debt in terms of hedging and replication of cash flows.  Now from now on we will refer to them as short term interest rates (STIRS) of this class they make up a medium segment.  There is also the short sterling, euroswiss, euribor, and many others listed abroad.

Next time around, we will discuss trading methods.

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Comments
  1. […] Eurodollar term structure February 2010 […]

  2. Rose says:

    Hi – I don’t understand your covariance chart at the end…. covariance of sd vs correl only gives one number, what is represented on the chart?

    Cheers

    • autospreader says:

      Ah thanks! I didn’t clearly note what the graph was displaying. You are seeing is the diagonal of the covariance matrix in that graph where the covariance matrix is constructed from the price changes of the Eurodollar contracts over the period observed in the post.

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