What’s Driving Eurodollar Volumes?

Since their introduction on the Chicago Mercantile Exchange in 1981, Eurodollar contracts have gained the distinction of being the most liquid futures contracts in the world, with open interest routinely exceeding $4 trillion notional. Last year saw record volumes in both Eurodollar futures and options as market participants flocked to the contract now considered the primary hedging vehicle for swaps and other spread products. What factors are responsible for the success of Eurodollar futures and options and what are the likely trends in this marketplace?

From inception, Eurodollar futures have offered interest rate hedgers the significant advantage of being easily “bundled” or strung together to provide exposure to different parts of the Libor curve. The ability to structure trades anywhere along the 10-year Eurodollar curve and create “best-fit” hedges has been key to the contract’s success. Indeed, in 1994, the CME introduced the concept of trading Eurodollar packs and bundles as individually priced structures, further facilitating this “best-fit” hedge capability.

Another core benefit of the Eurodollar contract is its cash settlement feature (settlement price equals 100 minus spot three-month LIBOR at expiration) which has long made the contract a hedge of choice for investors looking to avoid the risk, complexity and cost associated with physical delivery.

Setting the Stage: The Need for Libor-Based Hedges

A number of extraneous factors have heightened the popularity of the Eurodollar contract, beginning with the collapse of Long-Term Capital Management in 1998. With the CME’s clearinghouse division essentially taking the other side of all futures transactions, market participants need not be concerned with the counterparty risk associated with over-the-counter trades. The flight to quality that followed the demise of LTCM also highlighted the underperformance of Treasury hedges put in place by corporations to protect against rising interest rates. Corporate issuers concluded that Libor-based hedges would work better than Treasury-based hedges since swap spreads generally tend to track corporate spreads, especially during such flight-to-quality regimes.

Another important source of demand began to emerge in the late 1990s, when mortgage market participants found themselves exposed to increased volatility in the spread between mortgages and Treasuries. Starting in fiscal 1998, the Treasury started running a budget surplus. As these surpluses grew in the years that followed, the markets started speculating that all Treasury debt eventually would be eliminated. A scarcity premium caused Treasuries to rally relative to spread product and made the mortgage/Treasury basis more volatile. This increased volatility prompted mortgage market participants to seek out Libor-based hedges, further boosting the allure of Eurodollar futures and options (See Swap Futures: On the Verge of Success in Outlook 03: An FIA Special Report).

In response to growing budget surpluses, the Treasury started debt buybacks in January 2000 and eliminated the long bond in October 2001. This profound shift prompted spread markets to gravitate toward swaps as the benchmark curve against which assets are valued. The swap market started to take on a life of its own and trading volumes rocketed higher. Since the Eurodollar pit so clearly offers swap dealers a liquid and highly correlated hedge, Eurodollar volumes soared along with swaps (Figure 1).

The Driving Forces: Fed Expectations and Mortgage Refinancing

The swap and Eurodollar rage continued in 2001 as the Fed cut short-term rates an unprecedented 11 times from a fed funds target of 6.50 percent in January to 1.75 percent in December. Hedging and speculative activity, as one might imagine, went on at a fast and furious clip throughout the year in both futures and options.

Although there was only one Fed move in 2002 (a 50 basis point ease in November), the year was fraught with the anticipation of Fed activity. During the first half of the year, the markets expected the Fed to tighten, but when the economy failed to pick up strength, that stance gave way to expectations that the Fed’s next move would be an ease instead (Figure 2). This resulted in substantial Eurodollar flows, especially in the fronts/reds, as traders positioned and re-positioned their hedges. Whipsawing Fed expectations during 2002 also caused a substantial rise in Eurodollar option volatility, resulting in higher levels of option trading at the CME. Additionally, speculative swaption trading activity was concentrated in the one-year into one-year and one-year into two-year parts of the swap curve, a segment of the curve easily hedged with the most liquid Eurodollar option expirations.

Along with robust Fed speculation, Eurodollar volumes in 2002 were greatly influenced by the longest refinancing wave in U.S. history. With mortgage rates falling over 150 basis points during the year, the MBS refinancing index hit record levels. As mortgages shortened in response to the incessant rally, the option adjusted duration of the J.P. Morgan 30-year fixed rate MBS index fell from a high of almost four years to less than one year. This meant that mortgages were getting shorter in duration even as the market rallied, exposing mortgage portfolios to the risk of underperformance relative to the broad market. To hedge this “negative convexity” risk, mortgage investors looked to the Eurodollar option pits. Swaption trading activity also increased, which led to further interest in Eurodollar options.

To be sure, activity in Eurodollar options tends to increase with increasing implied volatility (Figure 3). This is not surprising since higher volatility usually implies higher risk aversion, which translates to increased hedging activity. As expected, Eurodollar option volumes have kept pace with a commensurate increase in swaption volumes as swaption dealers continue to see the Eurodollar option market as a liquid, highly correlated hedging choice. Anecdotal evidence, however, suggests that Eurodollar option volumes have gotten an additional boost in the form of direct participation from mortgage market players and increasingly aggressive hedge funds.

Looking Ahead: Several Factors to Watch

Going forward, volatility is likely to remain high in the near term due to two factors. First, the dual threats of war and terrorism have substantially raised the level of uncertainty among market participants. Second, a sustained rally in the fixed income markets over the past three years has brought mortgage durations close to their all-time lows. Continued high levels of refinancings, combined with what some see as a long overdue market sell-off, has the potential for substantially worsening the convexity profile of the mortgage market. For example, a 50 basis point increase in rates is expected to increase the duration of the J.P. Morgan 30-year fixed rate MBS index by one full year. This will lead to increased demand for convexity as mortgage market participants seek to hedge their extension risk.

Both these factors are likely to keep upward pressure on volatility in the near term. Once the threat of war and extension risk have passed, however, we expect volatility to fall, and option volumes to follow.

Eurodollar futures volume will be influenced by various counteracting factors. As fixed income markets have become comfortable with derivatives, and risk management systems more sophisticated, market participants have realized the value of derivatives in hedging and making speculative bets. Anecdotal evidence suggesting that U.S. dollar Libor swap market volume is showing no sign of letting up, which is likely to have a positive impact on Eurodollar futures activity. Additionally, if the Fed starts to tighten monetary policy later this year, the Eurodollar contract will see renewed interest. On the other hand, some market participants will be less active on Eurodollar futures once the pace of MBS refinancings slows down and the threat of extension risk has passed. Z

David Hartney is CME trading floor manager for J.P. Morgan Futures Inc. and a sales specialist in Eurodollar options. Pavan Wadhwa is a vice president in the fixed income research group at J.P. Morgan Futures, working with clients to develop optimal hedging strategies and to identify relative value trades. He also teaches seminars on derivatives and has published research in finance journals.