I don't know why I keep coming back to this sort of spot where i get stuck in my conception of the implicit Eurodollar curve.. What am i missing here.. If you buy your notionally lending.. But I thought this was just a bet on the future rate of interest.. meaning I'm taking a bet on what the interest rate "will" be in the future on a three month rate.. That's not notional lending, that's just a bet on what will happen in the future.. I'm not really following how you can play the interest rate curve via eurodollars when they just represent 3 month interbank loans back to back.. It looks like all the contracts slowly converge on a lower interest rate.. Do the contracts out in the future typically always imply a higher interest rate and converge on a lower interest rate.. Of course except for those times i've read about when the curve inverts.. Why do ED futures follow the yield curve if they are only 3 month loans? Seems like to me , the steepener trade is the trade to have on right now.. rising interest rates.. like for example a steepner fly +z5/-h6/+m6 but it still doesn't make sense because it looks like it converges in the opposite direction all else being equal...
No, you are not lending. You are betting on a future 3 month strip of libor interest. The actual banks who are lending are getting that interest. You are purchasing a present discount value of that forward rate. THAT is why you are seeing convergence. It's the same way t-bill are priced. T-bills do NOT pay interest. The interest is imbedded in the present discounted price. The difference between the two is the t-bill is worth par at maturity and the eurodollar is worth whatever the avg 3 month libor rate is at that particular expiration. So the reason these products "converge" which is not really the right way to say it, is because as time passes, the discounted value becomes the present value. The ED follows the yield curve because if you stack all those 3 month terms on top of each other, you get a longer term curve. For example, if a bank lends money out in 3 month intervals and they roll these loans every 3 months, they should receive the same amount of cashflows as if they just did one 12 month loan. The same is true of t-bills, notes and of course then bonds. If the cash flows don't match, there is arbitrage. For example if 12 month paper generated $500 in interest but each 3 month strip over a year only generated $400, then you want to sell each of the 3 month strips and pay out $400 and buy the 12 month strip and get $500 and make $100 in risk free profits. Regarding a steepener, I told you there is an ETF for both the flattener and the steepener that you could put on simply or use them just for reference. Most people would probably tell you that the yield curve is expecting to steepen. And there in lies the rub. The forward curve is pricing that in. Therefore, if you want to make money off of this, you either need to find a mispricing somewhere on the curve or go the other way. Markets are prickly like that, they try to make it hard to make the obvious trade. I'm sure Marty will be along shortly to edit the above for any mistakes. I'm an equity guy after all, not fixed income.
Well, why don't you think of it this way? You're agreeing to lend notionally at some future point in time at a rate implied by the price you pay. This way, you're lending notionally, but it also happens to be a bet on what will happen in the future. Makes sense? No, this doesn't always have to be the case, just like crude doesn't always have to be in contango or backwardation. For instance, if your central bank is signaling a rate cut (like the Aussies were doing recently), you will end up with some contracts implying a rate below the "spot". The tricky thing about the world of rates is that, at the same time, there's also another elusive component, besides the central bank rate expectations. I am referring to risk premium, which, generally, always pushes rates implied by future contracts up. Not sure what you mean exactly, but the ED futures don't follow the yield curve, they ARE the yield curve. Think of it the way I mentioned previously. A continuous chain of 8 3m loans uniquely and fully defines a 2y rate. So the spot rates can be built from the forward rates implied by the EDs and vice versa. I should add that all this is covered much better by Antti Ilmanen in his papers. Right, but the fly isn't just a bet on rising rates, right? Specifically, whether it works or not also depends on when the mkt thinks rates will rise. For example, imagine that the mkt decides to believe that rates stay on hold till H6 and then will begin to rise very quickly after that. Your fly will get screwed. As to it converging in the wrong direction, why doesn't it make sense? You say rising interest rates make your fly work, right? How exactly does that happen? EDIT: looks like somewhat of a cross post w/Maverick. I don't think there are any major disagreements.
I realize we are revisiting things I've already had awakings to... Let me soak this in again.... And reply when I'm by the computer
1) You have almost 3 months "invested" in this thread and you're back where you started? :eek: 2) Instead of doing "exotic" combinations in Eurodollars, wouldn't it just be easier just to take "flyers" in the ultra-bond?
When I was younger I quite everything I wasn't good at or could not understand right away... That is different now .. I don't care how long it takes... It usually takes me a little longer then most to completely get things... But once I get it.. I know it like my name
4 three month spreads should trade at the same price the one year spread trades that is made up of them.. I realize I had that butterfly quoted backwards for the steepener expression.. A steepener fly is good for a rising interest rate environment.. Which is short the body.. Long the wings... Long contracts are short interest rates.. Making the short body a steepener trade
I build it with my broker.. I'm with IB... The fly and spreads are quoted from the exchange. With TWS at IB I use combo trader to build a sheet of flys and just watch them as i visualize the curve changing.