Saturday, June 20, 2009

The Debts of the Spenders: Eurodollar Futures Reminder

Just a reminder:

ED Futures are based off the following formula:

Price = 100 (1 – r)

For example, if a Eurodollar future is quoted at 99.25, this corresponds to an interest rate of .75%. (Anything <1% is effectively ZIRP)

Each .01 unit of price corresponds to a basis point, but it is called a tick.

Why it is important:

Eurodollar futures are HEDGES for fixed income and ESPECIALLY fixed income derivatives:

Ahem, can you say CDS, CLO, and other ABS junk?

When you see the contracts move down, that means the banks (most traders are bankers) are predicting HIGHER INTEREST rates and therefore WIDER spreads on the basis pt yields on the CMBX and CDX indices. Translation - LOWER prices for commercial real estate REITS and corporate/foreign bonds.

The thing I like about ED futures is that they are EXCHANGE TRADED - e.g. no shady OTC activity going on. Moreover, the ED futures market is one of the most liquid in the world (compare this to the Fed Funds rate). In fact, their very existence was formed as an alternative to the old practice of negotiating forward swap rates in bilateral contracts. That method took time and the buyer had to navigate a wide bid-ask spread (similar to what the ABS traders do today on their Bloomberg terminals). But in the old days, they had to use WATSON and wire requests.

Now, traders have the advantage of being able to look up where the market believes interest rates are headed in the next few days/weeks/months ahead anytime they want (either on exchange hours or through the Globex CME platform).

Disclosure - No position in ED futures. I simply use it as an analytical tool for watching greater market patterns.
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