Could someone explain how eurodollars are used to price Fed rate hikes?

Discussion in 'Financial Futures' started by livetransmissio, Apr 28, 2016.

  1. I understand the basic gist.

    I understand that if people think they will hike EDs sell off. I also understand that LIBOR rates will track the Fed Funds rate since people would just park their money at the Fed if LIBOR is lower.

    When looking at outright prices and spreads I get a bit lost.

    For example EDZ6Z7 is trading 25 bps. What does that imply? 2 hikes? 12.5 bps x 2?

    EDZ6 trading 99.13 right now. What does that imply apart from the expected LIBOR rate?

    Thanks
     
  2. Eurodollars are forward rates so in theory the difference in price can be interpreted as the average expected total hike over a given period. If the 1 month rate was 12.5bp higher then that probably means there is a 50% chance of a 25bp hike given that rates have usually changed by 25bp (though who knows about the future). You can disentangle the hikes over time, but not down below the granularity of the contracts (i.e. 3 months after the first few), nor can you say wether 25bp means a 50% chance of a 50bp hike or a 100% chance of a 25hp hike.

    BUT a couple of warnings:

    Eurodollar is a forecast of inter bank lending rates* not the central bank policy rate. So it could be that it looks like a hike is priced in but actually it's just the credit spread that's expected to change.

    Also more seriously all interest rates include both a risk premium and a forecast for what interest rates are expected to be. It's impossible to disentangle these using just the price. If you are serious about knowing expected rates you should use a survey based measure (easy to find if you have Bloomberg). There's a nice chapter in the book "Expected Returns" on this.

    GAT

    * well a forecast of what a bunch of guys pretend bank lending rates will be anyway
     
    wlnd likes this.
  3. Thanks.

    So at 25 bps or greater spreads imply a hike in the timeframe they capture? Less than 25 implies no hike?

    What would imply a cut?

    Sorry if I'm coming off a bit dense. Maybe I am.
     
  4. A 10bp spread could be interpreted as a 10/25 = 40% chance of a rise, 60% chance of no rise.

    A cut would be a negative spread. Eg if the price goes from 99 to 99.5 that implies a 50bp cut.

    GAT
     
  5. Thanks!
    Thanks!

    What about say a butterfly?

    For example EDZ6Z7Z8 trading at -2.0 bps
     
  6. In theory rate would go up and then down (or the other way round; I don't know what the quoting convention is). But that's probably silly. Fly spreads mostly aren't driven by bank expectations (hard core spread traders will know this is a slight simplification bit I don't want to introduce any more complexity into this post).

    GAT
     
  7. These flies are an expression of the shape of the path of rates, rather than levels.
     
  8. piezoe

    piezoe

    I think it would be a great help to you to read George Soros's, "The Alchemy of Finance", this is the single most important work written in the twentieth century for central bankers, and investors of all sorts and sundry ilks. It is not important however to Day traders or very short term "swing traders". They depend on something else entirely to make a profit. But anyone whose profit could be affected by macro economic events, to which currencies respond, and vice versa, would be hugely helped in their pursuit of profits by reading this book (get a later addition. It is is important in this instance, because Soros makes corrections and changes..) Even if you are bright with a strong economics and finance background, you should read through this book at least twice. It takes most people more than twice to comprehend all that is buried in those pages -- a work of brilliance.
     
    wlnd and conduit like this.