The Eurodollar Futures and Options Handbook

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Foreword

Part One The Emergence of the Eurodollar Market

Chapter 1 The Emergence of the Eurodollar Market

The Revolution in Finance

The Futures Revolution

Key Money Market Developments

Why Eurodollars?

Eurodollar Futures

The Death of CD Futures and the Birth of Eurodollar Futures

The Market for Interest Rate Derivatives at the Beginning of the
21st Century

Exchange-Traded Money Market Futures and OTC Interest Rate
Swaps

Options on Futures, Forward Rates, and Swaps

Markets around the World

Part Two Building Blocks: Eurodollar Futures

Chapter 2 The Eurodollar Time Deposit

Maturities and Settlement

Quotes

LIBOR and LIBID

Interest Calculations

Chapter 3 The Eurodollar Futures Contract

Contract Specifications

Contract Unit

Price Quote

Tick Size

Minimum Fluctuation

Listed Contract Months

Contract Month Symbols

Color-Coded Grid

Expiring versus Lead Contract

Trading Hours and Mutual Offset

Final Settlement Price

Last Trading Day

Value Dates

Additional Trading Facilities

Initial and Maintenance Performance Bonds

Volume and Open Interest

Other 3-Month Money Market Futures Contracts

Chapter 4 Forward and Futures Interest Rates

Deriving a Forward Rate from Two Term Deposit Rates

Locking an Effective Forward Lending Rate Using Eurodollar
Futures

Important Differences between Forward and Futures Markets

Determining the Fair Value of a Eurodollar Futures Contract

Richness and Cheapness

Forward Rates Are Break-Even Rates

Yield Curve Trades

Finding the Forward Term Deposit Curve Implied by Today's Futures
Rates

Chapter 5 Hedging with Eurodollar Futures

The Tool Is a Eurodollar Futures Contract

Basic Hedge Algebra

Deriving Present and Forward Values from Eurodollar Futures
Rates

Calculating a Forward Value (Terminal Wealth)

Calculating a Zero-Coupon Bond Price (Present Value)

Hedging or Replicating Forward Cash Flows

Forward Valuing the Gain or Loss on the Eurodollar Futures
Contract

Present Valuing the Gain or Loss on a Floater

Hedging or Replicating Present Values of Cash Flows

Calculating the Price of a Zero-Coupon Bond

Calculating the Present Value of a Basis Point

Finding the Hedge for a Zero-Coupon Bond

Faster Hedge Ratio Calculations with Calculus

Pricing and Hedging a Coupon-Bearing Bond

Managing Hedge Ratios

As Rates Rise or Fall

As Time Passes

Practical Considerations in Real Hedges

The Stub Period

Date and Term Mismatches

Whole Contracts

Credit Spreads

Variable Credit Spreads

Chapter 6 Pricing and Hedging a Swap with Eurodollar Futures

Fixed/Floating Interest Rate Swaps

Notional Principal Amount

Cash Flows in Arrears

Periodicity

Spot and Forward-Starting Swaps

Day-Count Conventions and Swap Yields

Approaches to Pricing and Hedging Interest Rate Swaps

Cash Flow Approach

Hypothetical Security Approach

Pricing a Swap Using the Cash Flow Method

Hedging a Swap Using the Cash Flow Method

Primary Effects

Secondary Effects

Calculating Hedge Ratios

Hedge Ratios Are Dynamic

Pricing a Swap Using the Hypothetical Securities Method

Hedging a Swap Using the Hypothetical Securities Method

Floating Rate Liability

Fixed Rate Asset

Find the Hedge Ratios

Pricing and Hedging Off-the-Market Swaps

Convexity Differences between Forward and Futures Rates

Comparing Three Yield Curves: Forward, Zero Coupon, and Par
Coupon

The Difference between Money Market Rates and Bond Yields

Part Three Eurodollar Futures Applications

Convexity Bias (Chapters 7 through 10)

Term TED Spreads (Chapters 11 and 12)

Hedging and Trading with Eurodollar Stacks, Packs, and Bundles
(Chapter 13)

Hedging Extension Risk in Callable Agency Notes (Chapter 14)

Opportunities in the S&P Calendar Roll (Chapter 15)

Trading the Turn (Chapters 16 and 17)

Chapter 7 The Convexity Bias in Eurodollar Futures

Galen Burghardt and William Hoskins Research note originally
released September 16, 1994

Synopsis

Introduction

Interest Rate Swaps and Eurodollar Futures

A Forward Swap

The Value of a Basis Point

Eurodollar Futures

Reconciling the Difference in Cash Flow Dates

Hedging the Forward Swap with Eurodollar Futures

The Other Source of Interest Rate Risk in the Forward Swap

Interaction between the Two Sources of Risk

Trading the Hedge

How Much Is the Convexity Bias Worth?

How Correlated Are the Rates?

Estimating the Value of the Convexity Bias

Calculating the Value of the Bias

Reconciling the Difference between a Swap and a Eurodollar Futures
Contract

How One Would Pay for the Advantage

Translating the Advantage into Basis Points

A Workable Rule of Thumb

Applying the Rule of Thumb

The Importance of Time to Contract Expiration

The Cumulative Effect of All This Drift

How Sensitive Are the Estimates to the Assumptions?

Practical Considerations in Applying the Rule

The Importance of the Bias for Pricing Term Swaps

Biases in Forward Swap Rates

The Market's Experience with the Convexity Bias

Now What?

Running a Receive Fixed, Pay Floating Swap Book

Marking a Swap Book to Market

Volatility Arbitrage

Evaluating Term TED Spreads

APPENDIX A Deriving the Rule of Thumb

APPENDIX B Calculating Eurodollar Strip Rates and Implied Swap
Rates

Chapter 8 Convexity Bias Report Card

Galen Burghardt, William Hoskins, and Niels Johnson Research note
originally released April 15, 1997

What Is the Convexity Bias?

How Have We Done?

Convexity Bias Greeks

Convexity Bias Delta

Convexity Bias Vega

Convexity Bias Theta

Chapter 9 New Convexity Bias Series

Galen Burghardt and Lianyan Liu Research note originally released
February 1, 2002

Chapter 10 Convexity Bias: An Update

Chapter 11 Measuring and Trading Term TED Spreads

Galen Burghardt, William Hoskins, and Susan Kirshner Research note
originally released July 26, 1995

Synopsis

TED Spreads

Simple TED Spreads

Term TED Spreads

Two Kinds of Term TED Spreads

Unweighted Eurodollar Strip Yields versus Treasury Yields

Weighted Eurodollar Strip Yields versus Treasury Yields

Implied Eurodollar Yield versus Treasury Yield

Fixed Basis Point Spread to Eurodollar Futures Rates

How Do These Rates Compare?

How Directional Is the Spread?

Trading the Spreads

Hedge Ratios

What to Do with the Stub

Overnight Financing

Term Financing

Carry and Convergence

Convexity

Forward Term TED Spreads

Term TED Spreads and Swap Spreads

APPENDIX Complete Operating Instructions for Calculating Term TED
Spreads and Hedge Ratios

Chapter 12 TED Spreads: An Update

Chapter 13 Hedging and Trading with Eurodollar Stacks, Packs, and
Bundles

Galen Burghardt, George Panos, and Fred Sturm Research note
originally released December 15, 1999

Synopsis

Three Objectives

How Good Are Stack, Pack, and Bundle Hedges?

Curve-Augmented TED Spreads?

Hedging and Trading with Eurodollar Stacks, Packs, and Bundles

Basics: Dates, Names, Packs, Bundles, and Quotes

Contract Colors

Packs and Bundles

Quote Practices 1: Ticks

Quote Practices 2: Use Price Level for Individual Contracts

Quote Practices 3: Use Price Changes for Packs and Bundles

Unpacking Packs, Unbundling Bundles

Hedging with Stacks, Packs, and Bundles

What Happens to the Correlations?

Best Pack Proxies for Key Treasury Maturities

Horizon Matters

The Dangers of Decorrelation

Scaling Your Hedges to Reduce Hedge Error

Trading Curve TEDs

Calculating the Hybrid Spread

Looking for Opportunities

Chapter 14 Hedging Extension and Compression Risk in Callable
Agency Notes

Galen Burghardt and William Hoskins Research note originally
released March 24, 1995

Synopsis

Introduction

What Is the Exposure in a Callable Agency Issue?

Extension and Compression Risk

A Packaged Deal

What Is the Package Worth?

What Is the Risk Exposure?

Structuring a Hedge

The Option Is Tougher

Focus on Delta Hedging

Synthetic Forward Notes

Different Deltas

Example of Hedging a 10-Year, 8.5 Percent Coupon Note, Callable in
5 Years

Step 1: Find the Price of the Forward Note

Step 2: Find the Embedded Option's Delta

Step 3: Calculate Spot Market Hedge Ratios

Step 4: Calculate Futures Hedge Ratios

Step 5: Adjust the Hedge as Interest Rates Change

The Costs and Risks of Delta Hedging

Risks in the Hedge

The Yield Spread between Agencies and Treasurys

What If There Is Little or No Call Protection?

Sometimes Strips of Eurodollar Futures Provide Better Hedges

Netting Positions

Adjusting the Hedges

Chapter 15 Opportunities in the S&P 500 Calendar Roll

Galen Burghardt and George Panos Research note originally released
June 7, 1999

Synopsis

Save 15 Basis Points per Year on the Roll

Eliminate Interest Rate Risk in the Roll

Earn Superior Money Market Returns

The Value of the Calendar Spread

Fair Value of the Spread

Implied Financing Rate

How the Calendar Spread Has Behaved

What Is Your Exposure to Interest Rates?

Handling Rate Exposure in the Roll

Hedging against Interest Rate Risk

Cash Management and Portfolio Replication

Chapter 16 Trading the Turn: 1993

Galen Burghardt, Mike Bagatti, and Kevin Ferry Research note
originally released October 25, 1993

Synopsis

What Is "the Turn"?

Two-Day Turns

Three-Day Turns

Four-Day Turns

Rate Behavior around the Turn

Effects on Eurodollar and LIBOR Futures Prices

Rule of Thumb for a 4-Day Turn

Rule of Thumb for a 3-Day Turn

Rule of Thumb for a 2-Day Turn

Implied Turn Rates

Implications for Futures Spreads

December LED Spread

December/January LIBOR Spread

December/March Eurodollar Spread

December TED Spread

Effect of the Turn on LIBOR and Eurodollar Volatilities

Theoretical Turn Volatility Premiums

So What?

The Risks in the Trade

Chapter 17 The Turn: An Update

Hedging the Stub

Part Four Building Blocks: Eurodollar Options

Chapter 18 The Eurodollar Option Contract

Option Expirations and Underlying Futures

Standard Quarterly Options

Serial Options

Mid-curve Options

Five-Year Bundle Options

Option Contract Specifications

Contract Unit

Price Quote

Tick Size

Minimum Fluctuation

Strike Price Increments

Listed Contract Months

Contract Type and Month Symbols

Sample Option Quotes

Trading Hours

Last Trading Day

Exercise of Option

Assignment

Chapter 19 Price, Volatility, and Risk Parameter Conventions

Pricing Options on Futures

Option Price (Market)

Volatility

Relative Rate Volatility

Rate (Basis Point) Volatility

Period Volatility

Implied Volatility

Risk Parameters

Delta

Gamma

Vega

Theta

Rho

Intrinsic and Time Value

Chapter 20 Caps, Floors, and Eurodollar Options

Chapter 21 Structure and Patterns of Eurodollar Rate Volatility

Historical, Implied, Realized, and Break-Even Volatilities

Term Structure of Eurodollar Rate Volatility

Volatility Calendar Spread Trade

Yield Curve Trade

Maturity Structure of Volatility (Volatility Cones)

Volatility Skews

Implied Rate Distributions

Chapter 22 Practical Considerations

Early Exercise

Cash Settlement and Exercise

Part Five Eurodollar Option Applications

Trading with Serial and Mid-curve Eurodollar Options (Chapters 23
and 24)

What Happens to Eurodollar Volatility when Rates Fall? (Chapters 25
and 26)

Hedging Convexity Bias (Chapter 27)

Chapter 23 Trading with Serial and Mid-curve Eurodollar Options

Galen Burghardt and Scott Lyden Research note originally released
June 22, 1998

Synopsis

Eurodollar Strategy Triangle

FOMC and Other Volatility Trades

Spreads against OTC Treasury Options

LIFFE Joins the Crowd

The Full Constellation of Eurodollar Options

Standard Quarterly Options

Serial Options

Mid-curve Options

Serial 1-Year Mid-curve Options

The Beauty of This Design

The Eurodollar Strategy Triangle

June/Short June (A Yield Curve Spread)

Short June/Red June (A Time Decay Spread)

March/Red June (A Volatility Curve Spread)

Different Volatility Horizons

Mid-curve Options versus OTC Treasury Options

Eurodollar/Treasury Volatility Spread Trading

How Do You Compare the Volatilities?

How Do You Construct the Trades?

Some Things to Keep in Mind

LIFFE's Options

Chapter 24 Serial and Mid-curve Options: An Update

Chapter 25 What Happens to Eurodollar Volatility When Rates
Fall?

Galen Burghardt, George Panos, and Eric Zhang Research note
originally released October 18, 2001

Background

Was Volatility Rich or Cheap?

Volatility and Rate Levels

Why Relative Rate Volatility?

What Is the Evidence?

Is it the Fed?

Practical Consequences

Chapter 26 Eurodollar Volatility: An Update

Chapter 27 Hedging Convexity Bias

Galen Burghardt and George Panos Research note originally released
August 2, 2001

Synopsis

The Challenges

Overcoming the Challenges

Hedging a 4-Year Swap/Eurodollar Position

Gamma

Vega

Eurodollar Options

Gamma Mismatch?

The Choice?

Robustness?

Glossary

Index

About the Author

Footnotes

Chapter 1

Footnote 1

Chapter 3

Footnote 1

Footnote 2

Chapter 4

Footnote 1

Footnote 2

Footnote 3

Footnote 4

Footnote 5

Chapter 6

Footnote 1

Chapter 8

Footnote 1

Footnote 2

Chapter 11

Footnote 1

Footnote 2

Chapter 13

Footnote 1

Chapter 14

Footnote 1

Chapter 17

Footnote 1

Chapter 18

Footnote 1

Chapter 21

Footnote 1

Footnote 2

Chapter 23

Footnote 1

Footnote 2

Glossary

Footnote 1

McGraw-Hill authors represent the leading experts in their fields and are dedicated to improving the lives, careers, and interests of readers worldwide

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