Eurodollar Futures Explained

Eurodollar Futures Explained

Eurodollar (LIBOR), /GE on ToS, and @ED on others

There is a trade in the Futures Week Ahead that considers buying a Eurodollar spread. I want to cover some Eurodollar basics with you before we discuss the trade, so it makes a bit more sense.

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This contract alone moves more volume than any other CME product. There are days when a single call or put strike on a single Eurodollar option trades more volume than everything else that day. This speaks to the incredibly large depth of this market. There's 10 years worth of quarterly contracts listed at any time, I'd say most of the liquidity is within the first 3-4 years. The rest are nowhere near as liquid, but still tradable. As of today, I wouldn't consider going past Dec 2023.

Contract Specs:

Margin Requirements: Depends on the contract month. Usually near dated contracts have lower margins than back month contracts. Normally the margin for a single contract is between $450 – $750.

The contract has a notional value of $1,000,000.00 – and represents the interest for a 90-day “loan” of $1M which starts on the day the contract expires.

Real World Use Cases

Let's pretend we are a firm that received a loan for $100,000,000.00 at a rate of LIBOR + 25 basis points from our bank. The loan has a 5yr term, with a quarterly reset period. Every quarter your loan's interest “resets” based on the prevailing LIBOR rate for that quarter.

– We know the amount of the loan, 100M
– We know the +25 basis points won't change
– We know what the current LIBOR rate is for the next 3 months (as this is the one used for the first quarter of our loan).
– We DON'T know where LIBOR will be passed this first quarter…

This firm has $100,000,000.00 (100 mill) of variable rate loans on their books. If rates were to rise, the cost of servicing their loan may become a problem since it resets every quarter.

So what can they do?

They can convert this variable rate loan into a “fixed” one by doing a bit of financial engineering with these Eurodollar contracts. There are MANY ways that companies do this… This is just an example of one.

If they like the current interest rates of the LIBOR (Eurodollar futures) from the shortest duration contract all the way out 5 years, they can sell futures along the maturity curve.  This way, they are always “covered” by an active future contract as each 3 month period passes. Since its $100M, we would need approx 100 contracts – and effectively “lock-in” a rate for the loan.

If LIBOR were to spike, their short futures along the timeframe of their loan will appreciate in value, making up for the new additional costs their loan will cost them to service. If LIBOR rates go down, the company loses on the futures, but now has a lower debt service cost that makes up for the loss. Regardless of direction, they are effectively “fixed” even though the loan with the bank is still variable.

Price

The prices of /GE contracts are expressed as a normal-looking decimal number. This is called “IMM Notation.” For any contract using “IMM notation” (Eurodollars, Fed Funds, and others) – ALWAYS subtract the contract price from 100 to get the LIBOR rate being implied.

So, for example, if /GEZ20 is trading for 98.45, the rate/yield is 1.55% (100 – 98.45 == 1.55).

The same thing is true for Fed Funds. If you take 100 – /ZQF20, it leaves you with the fed funds rate implied by the Jan 2020 contract.

Just like bonds, as prices move up, interest rates go down. As prices fall, rates go up. Don't you wish it were that easy to get the yield from a Treasury future? ) I sure do.

DV01 (we don't care!)

WTH is a DV01? The Dollar Value of 1 basis point move in the underlying. Complex stuff we need to deal with when trading US Treasuries. Not Eurodollars though! ALL contracts have a fixed DV01 of $25.00 – meaning if the price moves from 98.45 to 98.44, a 0.01 move, the P/L is $25.00.

One thing to consider, just like Treasuries, longer-dated contracts have a tendency to move more than front-month contracts. Although both legs of a spread will have a uniform $25.00 per 0.01, the back month spread may give you more movement than the front one. Not always, of course, just generally speaking.

Eurodollar Trades

Since Eurodollars live on the “short” end of the yield curve (ie – shorter than the 2 yr /ZT note), they tend to react to policy changes with more conviction than say a 10-year treasury note.

Likewise, given their deep liquidity, they tend to show expectations for future policy actions that the broader financial market has. For example, the Eurodollar curve inverted on June 13 2018. Almost 6 months prior to the first Treasury curve inversion. Eurodollars were claiming “rates are going down” since June of 2018, which they predicted correctly – 2019 started with a pause, then rate cuts.

So far during the past 2 years, the Eurodollar contracts have been a great proxy for what the market thinks Fed is to do next. The market changes its view from time to time though… That's where the opportunity is at

NOTE: CME's FedWatch tool – which predicts Fed meeting outcomes and assigns probabilities is based strictly on Fed Fund futures prices. The same thing could be done with Eurodollars and still produce accurate probabilities.

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==== Resources ====

 

* Eurodollar basics – CME Education

* Daily settlements, volume and OI data

* CME Fed Watch tool

* CME Fed Watch tool formula