eurodollar futures & fed rate hikes

[dougscott03]

Hi, if anyone could help me I would be most appreciated... Given that QE2 is about to end in June, the market should start pricing in a rise in rates. If so, it should also be just the start of the rate cycle, which could go on for several years, and, say, lead to a 5% increase in the Federal Funds Rate.

This should also lead to the Eurodollar futures contract to fall from 99.5 to sround 94.5 over the same period. This is all intuitive enough, however, I have a few Qs about how to best take advantage of this.

My thinking is that I should sell a contract will expiry about 40-45 days from now, and then roll it over to the next closest contract every month. This should lead to the smallest loss when rolling the contracts. However, as I have never traded them before I do not know of this would work in practice, or, if there is a better way to achieve this.

If this were to work, why wouldn't I just do this every month for the next, say, 36mths, until the fed stops raising rates? Seems too good to be true; a complete lay up trade.

Any help/feedback really appreciated... As we all know, you can't fight the fed... so if you can't beat him, join him...

 

[DashRiprock]

you know, this is a very good set of questions.

 

[Martinghoul]

Hi, if anyone could help me I would be most appreciated... Given that QE2 is about to end in June, the market should start pricing in a rise in rates. If so, it should also be just the start of the rate cycle, which could go on for several years, and, say, lead to a 5% increase in the Federal Funds Rate.

This should also lead to the Eurodollar futures contract to fall from 99.5 to sround 94.5 over the same period. This is all intuitive enough, however, I have a few Qs about how to best take advantage of this.

My thinking is that I should sell a contract will expiry about 40-45 days from now, and then roll it over to the next closest contract every month. This should lead to the smallest loss when rolling the contracts. However, as I have never traded them before I do not know of this would work in practice, or, if there is a better way to achieve this.

If this were to work, why wouldn't I just do this every month for the next, say, 36mths, until the fed stops raising rates? Seems too good to be true; a complete lay up trade.

Any help/feedback really appreciated... As we all know, you can't fight the fed... so if you can't beat him, join him...

Well, currently the mkt is pricing rates of arnd 4.5% by the end of 2015 (very roughly). So you can't do better than that (in fact, rolling will mean you do it worse than that). If you think rates are going to be higher by then, just sell the far Eurodollar contract, close your eyes and hope for the best. Just be aware that every moment that goes by with the Fed on hold, you lose money (that's negative rolldown for you), regardless of the mark-to-mkt fluctuations of your position.

EDIT: scose is right. Because yield curves contain a component of risk premium, in an overwhelming majority of cases you lose money by being short. This is especially true now, when the curve is extremely steep.

 

[scose-no-doubt]

As far as I know, the futures are priced to negate any benefit in holding a spot or front month and continually rolling. My amateur and unqualified assumption is that this type of trade would have to be played by deciding which part of the curve would be most sensitive to hikes and trading that contract. Then you'd have issues with vol and liquidity and open yourself up to other risks that I don;t really understand. Hopefully Martinghoul will pop in. He's been around earlier today and is prob your best bet.

 

[scose-no-doubt]

Timing lulz

 

[scose-no-doubt]

MG what formulae do you use to value bonds or ascertain yield and PV/discounts and that?

 

[Martinghoul]

MG what formulae do you use to value bonds or ascertain yield and PV/discounts and that?

Well, there isn't a single formula. Basically, you have a bunch of mkt instruments that you use to build a curve. By that I mean you compute a set of continuously compounded discount factors for every single day out to 30y or 50y. Given these discount factors, you can value any given set of cashflows.

 

[dougscott03]

Well, currently the mkt is pricing rates of arnd 4.5% by the end of 2015 (very roughly). So you can't do better than that (in fact, rolling will mean you do it worse than that). If you think rates are going to be higher by then, just sell the far Eurodollar contract, close your eyes and hope for the best. Just be aware that every moment that goes by with the Fed on hold, you lose money (that's negative rolldown for you), regardless of the mark-to-mkt fluctuations of your position.

EDIT: scose is right. Because yield curves contain a component of risk premium, in an overwhelming majority of cases you lose money by being short. This is especially true now, when the curve is extremely steep.

Thanks. Makes sense. Something that seems too good to be true, almost always is... Putting that misguided trade aside, what other ideas do people have for hedging longer term interest rate risk? One idea that was suggested to me by a much smarter colleague would be to buy long dated (3 yr), 30-50% out-of-the-money, call options on the S&P. Vl is low and the interest rates to price the calls are the current, not future rates. I think, but need to check, a 130% call 3 yrs out on the s&p would cost around 3% of premium... If rates rise quickly in he next two years, even if the mkt falls, the value of the option should rise, due to higher rates. Ay thoughts, or suggestions on other strategies?

 

[DashRiprock]

MG what formulae do you use to value bonds or ascertain yield and PV/discounts and that?

this could well be right out but from 3m - 2yr is done on IBOR rates inferred from STIR futures, and after that its all done from the swap rates.
(obviously a bit of interpolation from repos or whatever to match the value dates etc)

MG am I right out? credit and counterparty risk exempt etc (for sake or argument)?

EDIT: This is sort of a general rule... it assumes you are going to the market for your funding and have a typical IBOR rating. Some people wont be able to borrow money at these rates so pricing instruments with them is futile, likewise some can fund at better rates.

But, unless MG knocks me for 6, those rates are fine to use for indicative purposes.

 

[Martinghoul]

this could well be right out but from 3m - 2yr is done on IBOR rates inferred from STIR futures, and after that its all done from the swap rates.
(obviously a bit of interpolation from repos or whatever to match the value dates etc)

MG am I right out? credit and counterparty risk exempt etc (for sake or argument)?

EDIT: This is sort of a general rule... it assumes you are going to the market for your funding and have a typical IBOR rating. Some people wont be able to borrow money at these rates so pricing instruments with them is futile, likewise some can fund at better rates.

But, unless MG knocks me for 6, those rates are fine to use for indicative purposes.

Well, you're roughly right, dash (apart from a few minor issues). However, in the brave new post-crisis world there's so much complexity arnd these seemingly simple matters, it's not even funny (complexity that was being previously ignored). So you have to be very careful, even for indicative purposes.

 

[Martinghoul]

Thanks. Makes sense. Something that seems too good to be true, almost always is... Putting that misguided trade aside, what other ideas do people have for hedging longer term interest rate risk? One idea that was suggested to me by a much smarter colleague would be to buy long dated (3 yr), 30-50% out-of-the-money, call options on the S&P. Vl is low and the interest rates to price the calls are the current, not future rates. I think, but need to check, a 130% call 3 yrs out on the s&p would cost around 3% of premium... If rates rise quickly in he next two years, even if the mkt falls, the value of the option should rise, due to higher rates. Ay thoughts, or suggestions on other strategies?

I don't see why the value of your SPX calls would rise when rates rise. I think it's a very bad idea to buy long-dated OTM calls on Spooz. If you could, the smart trade to do is selling puts, like Buffett. However, unless you have as much cash as he does, I wouldn't recommend it.

Generally, if you wanna be short (bet on higher rates sooner) sell Eurodollars outright, or buy Eurodollar puts.

 

[scose-no-doubt]

Well, there isn't a single formula. Basically, you have a bunch of mkt instruments that you use to build a curve. By that I mean you compute a set of continuously compounded discount factors for every single day out to 30y or 50y. Given these discount factors, you can value any given set of cashflows.

any recommended reading?

 

[dougscott03]

I don't see why the value of your SPX calls would rise when rates rise. I think it's a very bad idea to buy long-dated OTM calls on Spooz. If you could, the smart trade to do is selling puts, like Buffett. However, unless you have as much cash as he does, I wouldn't recommend it.

Generally, if you wanna be short (bet on higher rates sooner) sell Eurodollars outright, or buy Eurodollar puts.

thanks

 

[Martinghoul]

any recommended reading?

How technical do you like your reading, scose?

 

[scose-no-doubt]

With at least a few words.

 

[Martinghoul]

With at least a few words.

Sorry, can't help then ...

I always recommend the same few sources. Antti Ilmanen's "Understanding the Yield Curve" series is brilliant. Tuckman's "Fixed Income Securities" and Burghardt's "Handbook of Eurodollar Futures and Options" are sort of the classics.

 

[gooseman]

I don't see why the value of your SPX calls would rise when rates rise. I think it's a very bad idea to buy long-dated OTM calls on Spooz. If you could, the smart trade to do is selling puts, like Buffett. However, unless you have as much cash as he does, I wouldn't recommend it.

Generally, if you wanna be short (bet on higher rates sooner) sell Eurodollars outright, or buy Eurodollar puts.

what is your view on put skew if and when they go? similar form to ebor and ster? paaaaaaaaain

 

[Martinghoul]

what is your view on put skew if and when they go? similar form to ebor and ster? paaaaaaaaain

You mean in Edollars? Don't have a strong view on the skew in STIRs, tbh. OTC has some juicy stuff, otoh.