Central Bank of Egypt Eurodollar Futures Contracts Central

Central Bank of Egypt Eurodollar Futures Contracts

Central Bank of Egypt An Introduction Eurodollar Futures Contracts Ø Were first listed by the Chicago Mercantile Exchange (CME) in December 1982 Ø Most liquid futures in the world as measured by daily volume and open interest Ø Very elegant, valuable, and cost effective investment tool Ø When trading, relevant issues to take into consideration are Ø Macro policy Ø Economic outlook Ø Central bank policy action rate Ø Fall under the “derivatives” asset class

Central Bank of Egypt A Definition Ø Eurodollar Futures Contracts Ø Futures contracts with final futures price based on threemonth LIBOR at the expiration date Ø Derive their value from underlying deposit rate on Eurodollar 3 -month deposit Ø Cash settled which means that no actual Eurodollar deposit is transacted at the maturity of the contract

Central Bank of Egypt Eurodollar Futures on Bloomberg

Central Bank of Egypt Bloomberg Screen of Eurodollar Future

Central Bank of Egypt Contract Specifications Ø Contract Unit Ø Eurodollar time deposit with a $1, 000 principal value and a 3 month maturity Standard settlement period of a time deposit is two days Deposits are add-on as opposed to discount instruments Interest rates are quoted on the basis of standard money market day counts ACT/360 Ø Price Quote Ø 100 – annualized futures interest rate Ø Bids and offers are quoted in terms of the IMM (International Money Market) index, or 100. 00 minus the yield on annual basis for a 360 day Ø Example: what will be the price quote of a Eurodollar contract with an underlying deposit rate of 3. 25? Ø Ø Ø

Central Bank of Egypt Contract Specifications Ø Tick Size Ø Basic tick size or price fluctuation is 0. 01 (or 1 basis point) Ø Dollar value of a tick calculation: Notional amount * Time * 1 bp change = Price change $1, 000 * 90/360 * 0. 01% = $ 25 Ø Ø Minimum fluctuation Ø Regular: 0. 01 = $25 Ø Half tick: 0. 005 = $12. 50 for all months except nearest expiring Ø Quarter tick: 0. 0025 = $6. 25 for nearest expiring month

Central Bank of Egypt Contract Specifications Ø Settlement Ø Cash settled Ø Clearing house responsible for settlement process Financial integrity of futures exchange ensured by the clearing house Responsible for settling trading accounts, clearing trades, requiring delivery, and reporting trade data Customer's position is marked to market daily Gains or losses are posted to the customer's performance bond account If the customer's funds drop below the maintenance performance bond level, customer will need to post additional margin. Ø Ø Ø

Central Bank of Egypt Contract Specifications Ø Final settlement price Ø 100 – British Bankers Association 3 -Month LIBOR mark Ø Last trading day Ø 11: 00 a. m. London time on the second London bank business day before third Wednesday of the contract month Ø Delivery day Ø Cash settled on the third Wednesday of the contract month

Central Bank of Egypt Contract Specifications Ø Contract Months Ø Trade ten years into the future for the months of March – “H” June – “M” September – “U” December – “Z” Ø Contract Terminology Ø How to understand the details of a contract through its name Ø EDM 6 ED – Eurodollar M – June 6 – 2016 expiry Ø Ø Ø Ø

Central Bank of Egypt Entering into a ED contract Ø When buying or longing a Eurodollar, effectively the investor is: Ø Investing in $1, 000 3 -month future Eurodollar time deposit at a specific rate Ø Investor is lending out $1, 000 at a specific rate Ø Underlying Eurodollar deposit essentially begins on the expiration of the contract Ø No Eurodollar time deposit actually commences on the date of expiration Eurodollar futures are cash settled at expiration of the contract and simultaneous commencement of the Eurodollar deposit Ø

Central Bank of Egypt Entering into a ED contract Ø Example: Assume that an investor has bought a Eurodollar futures contract (EDH 7) at 99. 575. Ø What is the maturity date of this contract? Ø What is the underlying of the contract? Ø What is the investor’s position after purchasing the Eurodollar futures contract? Is the investor long or short? Ø Is the investor a borrower or a lender of the underlying? Ø What is the deposit yield of the underlying? Ø What will change hands at the maturity of the contract?

Central Bank of Egypt Entering into a ED contract Ø When selling or shorting a Eurodollar, effectively the investor is: Ø Shorting a $1, 000 3 -month future Eurodollar time deposit at a specific rate Ø Investor is borrowing $1, 000 at a specific rate Ø Underlying Eurodollar deposit essentially begins on the expiration of the contract Ø No Eurodollar time deposit actually commences on the date of expiration Eurodollar futures are cash settled at expiration of the contract and simultaneous commencement of the Eurodollar deposit Ø

Central Bank of Egypt Entering into a ED contract Ø Example: Assume that an investor has sold a Eurodollar futures contract (EDU 7) at 99. 650. Ø What is the maturity date of this contract? Ø What is the underlying of the contract? Ø What is the investor’s position after selling the Eurodollar futures contract? Is the investor long or short? Ø Is the investor a borrower or a lender of the underlying? Ø What is the deposit yield of the underlying? Ø What will change hands at the maturity of the contract?

Central Bank of Egypt Calculating Profit and Loss Ø A single basis point move in Eurodollar futures equals a $25 amount. Ø Recall Notional amount * Time * 1 bp change = Price change $1, 000 * 90/360 * 0. 01% = $ 25 Ø This translates into a simple, uncomplicated, elegant way to calculate profit or loss on a particular Eurodollar futures contracts position: Ø Profit/loss = number of contracts * change in bp * $25 Ø

Central Bank of Egypt Calculating Profit and Loss Ø If an investor buys Eurodollar futures and rates decrease as price increases, then the investor makes money Ø Inversely, if an investor buys Eurodollar futures and rates increase as prices decreases, then the investor loses money Ø If an investor sells Eurodollar futures and rates decrease as price increases, then the investor loses money Ø Inversely, if an investor sells Eurodollar futures and rates increase as prices decreases, then the investor makes money

Central Bank of Egypt Calculating Profit and Loss Ø Example: Ø Portfolio Manager buys 10 contracts of the EDM 7 at a price of 99. 61 Ø Two days later the price moves up to 99. 63 Ø Did the portfolio manager make or lose money? Ø What is the portfolio manager’s profit/loss?

Central Bank of Egypt Calculating Profit and Loss Ø Example: Ø Portfolio Manager sells 20 contracts of the EDZ 7 at a price of 99. 325 Ø Two days later the price moves up to 99. 375 Ø Did the portfolio manager make or lose money? Ø What is the portfolio manager’s profit/loss?

Central Bank of Egypt Duration of Eurodollar Futures Ø Duration of a Eurodollar futures contract is very simple Ø Duration is 0. 25 year per contract Ø DV 01 per futures contract is $25 Ø Assume that an investor wants to gain 1 year duration exposure to replicate a one year LIBOR’s duration exposure, how many contracts must the investor buy? Instrument Duration Number Required Total Duration 1 -Year LIBOR/ 1 Year Bill 1 Year 1 1 Year Eurodollar 0. 25 Year 4 1 Year

Central Bank of Egypt Hedging with Eurodollar Futures Ø Eurodollar futures can be used to hedge interest rate risk by using the following equation: Hedge ratio = DV 01 t / DV 01 h t = security being hedged h = hedging vehicle Ø If an investor wants to hedge the interest rate risk of $5 million 2 year Treasury bond with a DV 01 of $968, how many Eurodollar contracts must be purchased?

Central Bank of Egypt Taking Views on Central Bank Rates Ø Eurodollar futures are especially useful to an investor who wants to take a view on a Central Bank’s policy rates Ø Easy access to the most attractive portion of the short end yield curves in several regions of the world Ø Rule of thumb Ø Like bonds, market price of the Eurodollar futures moves opposite to rates Ø When a central bank eases rates, the price of a Eurodollar futures contract will rise Ø When a central bank tightens rates, the price of a Eurodollar futures contact will decline

Central Bank of Egypt Taking Views on Central Bank Rates Ø Eurodollar futures are often poor estimators of actual policy rate changes Ø For example, on June 2010 futures contracts priced in 200 bp of short term increases over the next 24 months Ø Eurodollar futures decreased in price while rates on them rose Ø Post Jackson Hole, Fed made it clear that policy rates would remain unchanged for a prolonged period Ø Eurodollar futures prices increased dramatically

Central Bank of Egypt Taking Views on Central Bank Rates Ø Investor with a robust view on rates could have added value by taking a position against market consensus Ø If an investor thinks the market has priced in excessive tightening, would a long or short position be lucrative? Ø If an investor thinks the market has priced in excessive easing, would a long or short position add value to the portfolio? Ø If an investor thinks the market has not priced in enough hikes, should the investor short or long Eurodollar futures? Ø Alternatively, if an investor thinks the market has not priced in enough cuts, should the investor short or long Eurodollar futures?

Central Bank of Egypt Packs and Bundles Ø Market participants often want to execute a series of Eurodollar futures contracts in order to target specific segments of the curve Ø Rather than execute each contract month individually and incur execution risk, packs and bundles can be used to execute all of the desired contract months in a single transaction

Central Bank of Egypt Packs and Bundles

Central Bank of Egypt Mechanics of Packs Ø Simultaneous purchase or sale of an equally weighted, consecutive series of 4 Eurodollar futures Ø Trade in quarter ticks Ø Quoted on average net change basis from the previous day’s close

Central Bank of Egypt Mechanics of Packs Ø Color coded contracts Ø Expiration years are depicted by color-coded grid, with 4 quarterly cycle contract expirations per color First four contracts - White Second four contracts - Red Third four contracts - Green Fourth four contracts - Blue Fifth four contracts – Gold Sixth four contracts - Purple Seventh four contracts - Orange Eighth four contracts - Pink Ninth four contracts - Silver Tenth four contracts - Copper Ø Ø Ø Ø Ø

Central Bank of Egypt Mechanics of Packs Ø DV 01 of a single pack is $100 (25*4=100) Ø Assume an investor buys 20 packs, what is the DV 01? Ø Packs can be used to express steepening/flattening trades Ø Example, in order to set up a 1 -2’s steepening trade, an investor can buy 5 white packs and sell 5 red packs. Ø What will the net DV 01 of this position be?

Central Bank of Egypt Mechanics of Bundles Ø Also involve the simultaneous purchase or sale of consecutive series of Eurodollar futures contracts Ø Have maturities of 1, 2, 3, 4, 5, 6, 7, 8, 9, and 10 years Ø For example, a two year bundle is the first eight contracts starting with the current contract Essentially, the investor buys the first two years of Eurodollar futures maturities What is the DV 01 of this two year bundle? Ø Question: how many contracts make up a five year bundle? What would the DV 01 of this bundle be? Ø Ø Ø

Central Bank of Egypt TED Spread Ø Calculated as the difference between the three month LIBOR rate and the three month T-bill interest rate Ø Can be thought of as the credit spread between US Treasuries and the LIBOR/Eurodollar market Ø Attractive because it unbundles credit risk and interest rate risk Ø Size of the spread is denominated in basis points Ø If the Eurodollar future trades at 5. 50% and the T-bill rate is 5. 10%, the TED spread is 40 bps

Central Bank of Egypt TED Spread Ø TED spread is an indicator of perceived credit risk in the general economy Ø T-bills are considered risk free Ø LIBOR reflects credit risk of lending to commercial banks Ø Buying the TED Ø Buying a treasury and selling a strip of Eurodollar futures contract to match the risk Ø Position is bullish on treasures and bearish on credit Ø Lucrative trade when markets are unstable and in turmoil Ø Selling the TED Ø Selling a treasury and buying a strip of Eurodollar futures contract to match the risk Ø Position is bearish on treasures and bullish on credit Ø Lucrative trade when there is relative growth in the economy

Central Bank of Egypt TED Spread Ø Example: Ø The economic indicators are taking a nose dive. The economy is looking more and more fragile by the day. The market seems to be pricing in a series of central bank rate cuts. Some banks have taken a huge hit as a result of the worsening economic conditions. Investors are beginning to question the viability of the banking sector. Ø Ø In this particular scenario, what will happen to the TED spread? Should the investor buy or sell the TED?

Central Bank of Egypt Fair Value of Eurodollar Futures Ø The fair value is attained by calculating the 3 -month implied forward LIBOR rate and subtracting it from 100: Rf= {[(1 + R 2({T 1+T 2}/360))/(1 + R 1(T 1/360))]-1}(360/T 2) f = the one-period forward rate starting at time T 1 R 2 = the longer period spot rate of T 1 + T 2 days R 1 = the shorter period spot rate of T 1 days T 1 = the number of days from the current date until the futures contract expires. T 2 = the number of days for the 3 -month futures rate, typically 91 days. Eurodollar Futures Fair Price = 100 - RF

Central Bank of Egypt Fair Value of Eurodollar Futures Ø In theory, arbitrage should keep the Eurodollar futures’ prices within the “fair price” band Ø A breakdown of the arbitrage process can discourage hedging as well as cause the overall volume on the contract to decrease because of the uncertainty of the pricing process Ø Fair price theory did not hold during the financial crisis Ø Major dislocation between the fair value of the contracts and the prices they were trading at in the market Ø Divergence between actual price and fair price of contracts reached over 100 bps Ø Reflected a meltdown in the interbank lending market fuelled by fear of counterparty credit risk Ø Today difference in actual and fair price converging but differences do remain

Central Bank of Egypt Fair Value of Eurodollar Futures