Hedging Interest Rate Risk with Eurodollars

Andy Waldock  |

It is time to look at alternative ways to hedge against rising interest rates. Unfortunately, with the huge increase in volatility due to so many headline issues from Greece to trading halts on the NYSE, that it makes it tough to hold onto positions. Fortunately, the most liquid interest rate market is structured in such a way that hedging against inflation can be done with a reasonably fixed amount of risk.

Eurodollar futures are not the same thing as the Euro Currency. Eurodollar futures are based on interest rates while the Euro Currency obviously trades in the cash currency markets, futures and forex. The Eurodollar futures represent the expected interest rate earned at expiration on US Dollar deposits held outside of the United States. The concept began to take shape after World War 2 when US Dollars were flowing to Europe at a breakneck pace. These Dollar deposits have been globalized over the last 50 years but the term, "Eurodollar" has stuck.

Eurodollar futures trade on an index priced from 0 to 100. While I don't know the interest rate that a price of 0 equates to, I do know that a price of 100 represents 0% interest earned over the life of that quarterly contract. The backdrop of losses being capped to a price of 100 and its corresponding 0% rate helps mitigate the risk in the hedge towards higher rates.

The second point is that Eurodollar volatility on a cash account basis is much lower than other interest rate markets like the 10-Year Treasury Note futures and the 30- Year Bond futures. Consider the long-term Eurodollar chart below. Eurodollar futures have gained 270 basis points in the last eight years. One basis point equals a $25 change in the holder's account per contract. Therefore, $6,750 could've been made in the last eight years holding Eurodollars as an investment. Finally, consider that initial margin for the Eurodollar is quite reasonable at the last reported rate of $275 per $1,000,000 controlled.

The two year buying spree by commercial traders has reversed course at the Eurodollar's all-time highs.

Compare that move in Eurodollars to the volatility of the 10-Year T-Notes and 30-Year Bonds which would've been $55,000 and $77,000 respectively on $100,000 contract values and the volatility difference becomes clear. Furthermore, neither the T-Notes or Bonds have capped ceilings anywhere near where we're trading. The T-Note futures would have to trade above 147 for yields to fall to 1% and that is more than 20 handles or, $20,000 from their current price around 127. It's obviously even more dramatic in the T-Bonds. They have to trade above 190 to reach a 1% yield and that is roughly 37 handles or, $37,000 above their current price near 153.

The point of reference on the previous chart indicates December Eurodollar futures trading near 99.50. At that price, traders are risking $1,250 per $1,000,000 contract on the chance that rates dive to zero. We don't think this will happen. Much of our emphasis for this lies with the fact that the commercial traders - the biggest elephants in the room, have broken their two year buying spree and have not only laid off their purchases but in fact, are entering new short sales thus indicating their expectations of rising rates ahead.

We always seek to put their leverage behind our trades and this is no exception. I'll happily defer to the market modelers, quants and boardroom negotiations that are the privilege of the commercial trader. Therefore, their selling is noteworthy. More importantly, the recent flight to quality due to Greece has provided us with a rally to sell.

Moving to the short-term chart, the trade becomes easy to see. Based on the disconnect between the current flight to safety and the Federal Open Market Committee's (FOMC) clear desire to begin raising rates here at home we've a golden opportunity to hedge interest rate risk through the rest of 2015.

Commercial traders have turned sellers in the Eurodollar futures. The recent flight to safety provides a golden opportunity to hedge interest rate risk through the end of 2015.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer


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