Riding the Eurodollar Rate Curve

There are 40 quarterly contracts available for trading three-month Eurodollar interest rates futures. Currently, you can trade front month September 2017 Eurodollars out quarterly to the September 2027 contract. For each contract the price is listed as 100 less a quarterly interest rate. For example, on Sept. 8, 2017, the price shown for the December 2017 futures contract was 98.625, a rate equal to 1.375%. With a relatively flat yield curve at present, the rate on the December 2026, contract was not much higher – 97.345, a rate of 2.655%.

“Eurodollar vs. Treasury yields,” (right) shows the relationship between Eurodollar futures and the Treasury yield curve on Sept. 25, 2017. Following the shortest-term interest rates that are coordinated with Libor (London Interbank offer rate), both the Treasury yields and Eurodollar rates move higher. Yields that are higher for longer-term bonds would be considered normal since investors are expected to require a higher return for longer-term investments.

The chart shows that short-term Eurodollar rates needed to move higher more quickly since they are responsible for lifting the Eurodollar yield curve so that it is close to the Treasury yield curve. For intermediate terms, such as three to five years through the longest maturities, the Eurodollar and Treasury yield curves are closely related with Eurodollar yields, slightly higher than Treasury yields.

Eurodollar vs. Treasuries
Investment decisions on Eurodollar futures take a different approach from decisions on Treasury bonds because bonds are priced according to their market yields vs. the bond’s yield to maturity — the present value of the bond after discounting future payments of interest and principal by the current required yield for the bond’s remaining time to maturity. Changes in the price of Eurodollar futures depend on the number of basis points (each equal to 1/100 of 1%) that the quarterly rate changes. Each basis point of rate change equals $25 – an amount determined by the underlying deposit of $1 million Eurodollars, over a quarter of one year, times the rate of 1% divided by 100.

The concept of riding the Eurodollar rate curve is related to the time-honored investment technique of riding the Treasury yield curve. When the Treasury yield curve contains higher yields for longer-term bonds, it is possible to gain value by investing long-term and allowing the gradual reduction in yield over future time periods to produce increases in the price of the purchased long-term bond.

Since it is assumed that Treasury securities have zero credit risk (after all, the government can always print enough money to pay its bills). The remaining risk, other than inflation is that interest rates might increase, resulting in reductions in the bonds’ present value or price. Interest rate risk for riding the Treasury yield curve depends on the national economic outlook and response by the Federal Reserve in causing rates and yields to rise or fall.

“Eurodollar vs. Treasury yields” exhibits a relatively stable economy with small changes due to decisions by the Fed. There have been changes in the rates on Eurodollar futures (see “Eurodollar futures changes in rates,” above). The chart combines time periods from June 21, 2017, to Sept. 18 and Sept. 25, 2017.

Profit from riding the Eurodollar rate curve – taking a long or short position on a Eurodollar contract – depends on rate changes for specific quarterly Eurodollar futures contracts such as those shown on “Eurodollar futures changes in rates.” Of course, the targets are quarters that show the greatest positive or negative movement in rates, depending on the trader’s forecast of interest rate changes. Several quarters around five years from the present time in September 2017 appear to be good choices for declining rates. For example, Eurodollar futures with expiration dates in 2022 and 2023 show negative tendencies.

How quickly a profit might be made from trading a Eurodollar futures contract will vary with interest rate movements in the market, but a relatively short time period may result. Going from June 21 to Sept. 25 and from Sept. 18 to Sept. 25, we find that there were several profitable trades.

Riding the Treasury yield curve and riding the Eurodollar rate curve are similar in that both trades profit from interest rate changes; however, Eurodollar futures have an advantage in permitting either long or short trades. Treasury securities are priced according to their yields, while Eurodollar futures are priced by short-term (90-day) interest rates.

The Eurodollar Advantage
Traders in Eurodollar futures have one advantage (see “Eurodollar futures rates less yields,” below). This chart indicates the most favorable quarters for riding the Eurodollar rate curve in long futures trades. It shows again that the five-year area of quarterly futures is probably the best for producing negative rate changes and profits on interest rate contracts.  

A short trade in Eurodollar futures might be profitable in the event that increases in Federal Reserve short-term rates were forecast. For this trade, the shortest quarterly contract would be the most profitable over a short time period. A hypothetical example is shown here (see “Effect of 100-basis-point increase,” below). Note the relatively large impact on the Treasury yield curve, short-term, and the relatively short time period over which the 100 basis point rate increase fades in its effect on farther out quarterly rates.

The short-term effects of changes in rates on the Federal Reserve’s favorite area of interest rate control – very short-term maturities – explain why the Fed was forced to purchase intermediate or longer-term bonds in its “Operation Twist,” after its first two rounds of quantitative easing. Even large rate changes in the shortest maturities would have had approximately zero impact on intermediate-term securities.

The rapid fading out of rate changes in any time period is related to the calculation of Eurodollar yields. Beginning with the rate at the most current quarter, each quarter’s calculated yield is equal to the Nth root of successive products as each quarterly rate is multiplied times the product of previous quarterly rates. The result is an exponential reduction in the impact of the rate change in any quarter. There is also the result that every yield shown on the Eurodollar yield curve and Treasury yield curve is an average of previous shorter-term rates.

The progression of Nth roots of interest rate products is the chain of geometric means — yields that are averages of shorter-term 90-day rates.

Profits or losses on trades from riding the Eurodollar rate curve tend to go in the same direction for all maturities on a given day, with the results depending on interest rate movements in the market. Unless interest rate changes are very large, profits and losses will be small for an individual futures contract. Ultimately the profit or loss will depend on the trader’s ability to forecast short-term interest rate changes.