The formula is derived by applying the following "no arbitrage" logic. Suppose someone wants to borrow $100 from you and you give them terms such that the 2y rate is, say, 5%, while the 1y rate is, say, 2% (assume interest simply paid at maturity). You extend a 2y loan in one of two ways: a) just lend straight today for 2y at 5%; or b) lend today for the 1st year at 2%, but also agree that when the first loan is repaid you will lend for the 2nd year at whatever the 1y rate at that future point in time happens to be (let's call it X). All else being equal and assuming that you don't know anything about the future, X should be a number such that you're indifferent between a) and b). That's exactly what the formula states.
you always seem to know what the F03* is going on... haha.. I get exactly what your saying.. I read about this in another futures trading book about being able to deliver whatever is the cheapest... Obviously your implying the easiest money is to trade where retailers are heavy
Like for many of the trades LTCM did, the idea that this "old bond" vs the "on-the-run" strategy makes money is, sadly, a misconception propagated by the press. In reality, the actual PNL on these strategies was very close to zero, 'cause the repo mkt just didn't play ball. A typical example of LTCM: a theoretically clever trade, which mostly got killed by frictions left out of the model. At any rate, maybe it's worth starting a different thread to talk about bond futures? Given the original subject here was Eurodollars...
So in your example the scenario of option B the second year or second segment/leg of the loan should be priced as if it was just the difference between the 1st year rate of 2% and the second year rate of 5% .. such that an investor would have no preference over taking a two legged contiguous 1 year loans, to 1 2 year loan.. is that what i hear you saying? i like this discussion alot... I keep hearing convexity in speaking about bonds.. and when i think of convexity i get stuck on otm option payout graphs haha..
This to me is one of the key reasons why i am interested in this particular trade... I trade vix options/futures.. and the thought of being long steepeners as a proxy for being long stocks(short volatility) is of interest to me.. The other thing Mav while it is useful i'm sure to learn about the cash market to futures market spread.. I don't have access to that.. I only have access to bond futures, eurodollar futures, vix futures, equities, commodities etc.. And i don't understand the downside of learning about this stuff?... i was a little curious why you were curious why i had my nose into this? I appreciate the fact that your paying attention to me to be honest
He's nitpicking. Eurodollars are traded off of Libor, not treasury rates. Or he could be nitpicking that bonds are the long end of the curve and eurodollars are the front end. Or he could just be pissed that London has like the worst weather on the planet. With Marty, you never know.
LOL. No, I just think sometimes people think a certain type of trade is one thing when in reality it's something completely different. Let me offer you an example. There was a guy who posted a few days ago about trying to hedge FX cash with FX futures. He thought there was an arb. I tried to explain to him that a trade in spot vs futures is not an FX trade at all, it's an interest rate swap. He thought it was an arb. So I politely explained to him that he was thinking about the trade incorrectly. It's an easy mistake to make. I'm not saying there is no arb there, but the arb is on the rate side, not on the FX side. So I saw you asking questions on this and I wasn't sure if you understood how guys actually trade this stuff. The rate market is dominated by swaps. There really aren't a lot of guys "playing the curve" as you are trying to do. I mean I'm sure there are plenty of global macro hedge funds that do and it's entirely predicated on economic fundamentals. But usually on the active trading side, it's a prop firm trying to exploit "kinks" in the curve. These kinks are VERY small, you almost need a magnifying glass to see them, but they trade these things in massive size. It's not the type of trade joe sixpack is going to do in his IB account. Nothing wrong with learning. I will preface that though by saying this and you have probably heard me say this countless times on the ACD thread, trading is about focus and priorities. How you focus your time is crucial. I think string theory is interesting. I just have absolutely NO time at the moment to study it. The rate market is insanely complicated. Don't believe me, pick up anything by Fabozzi that is 1600 pages thick and weighs 10 lbs and that is an intro guide! LOL. It's not something to read on the side. However there are many prop firms in Chicago (and London) that trade this stuff and if you landed a gig at one of these places, at least they would pay you for your time. But to try to "play around" with this stuff, I think you might be focusing in the wrong area. Just my opinion, I'm often wrong as I like to say.
I think the focusing concern is right on... there is nothing more pronounced in my trading career as losing money trading in products in which i had no deep understanding of.. yet paradoxically, i would not be trading at all if i hadn't bought apple options and lost 5k right off the bat way before i even know what theta was.. Those first trades propelled me so much further into trading, and in turn making money.. so i think of it as a double edge sword really.. A friend of mine had said the same thing to me about ACD because we don't really trade direction, and the idea of starting to try to get a handle on direction takes away from what we focus on trading curves in the first place.. yet in some way you are always trading direction.. Seems like nonsense.. and maybe it is.. but maybe i shouldn't let my curiosity wonder so much..