Could someone explain how eurodollars are used to price Fed rate hikes?

[livetransmissio]

I understand the basic gist.

I understand that if people think they will hike EDs sell off. I also understand that LIBOR rates will track the Fed Funds rate since people would just park their money at the Fed if LIBOR is lower.

When looking at outright prices and spreads I get a bit lost.

For example EDZ6Z7 is trading 25 bps. What does that imply? 2 hikes? 12.5 bps x 2?

EDZ6 trading 99.13 right now. What does that imply apart from the expected LIBOR rate?

Thanks

 

[globalarbtrader]

I understand the basic gist.

I understand that if people think they will hike EDs sell off. I also understand that LIBOR rates will track the Fed Funds rate since people would just park their money at the Fed if LIBOR is lower.

When looking at outright prices and spreads I get a bit lost.

For example EDZ6Z7 is trading 25 bps. What does that imply? 2 hikes? 12.5 bps x 2?

EDZ6 trading 99.13 right now. What does that imply apart from the expected LIBOR rate?

Thanks

Eurodollars are forward rates so in theory the difference in price can be interpreted as the average expected total hike over a given period. If the 1 month rate was 12.5bp higher then that probably means there is a 50% chance of a 25bp hike given that rates have usually changed by 25bp (though who knows about the future). You can disentangle the hikes over time, but not down below the granularity of the contracts (i.e. 3 months after the first few), nor can you say wether 25bp means a 50% chance of a 50bp hike or a 100% chance of a 25hp hike.

BUT a couple of warnings:

Eurodollar is a forecast of inter bank lending rates* not the central bank policy rate. So it could be that it looks like a hike is priced in but actually it's just the credit spread that's expected to change.

Also more seriously all interest rates include both a risk premium and a forecast for what interest rates are expected to be. It's impossible to disentangle these using just the price. If you are serious about knowing expected rates you should use a survey based measure (easy to find if you have Bloomberg). There's a nice chapter in the book "Expected Returns" on this.

GAT

* well a forecast of what a bunch of guys pretend bank lending rates will be anyway

 

[Martinghoul]

This should help a bit:
https://www.cmegroup.com/trading/in...funds-futures-probability-tree-calculator.pdf

This uses FF futures, so things should be a little easier, due to the absence of at least some of the concerns mentioned by gat. The logic is broadly the same.

 

[livetransmissio]

Eurodollars are forward rates so in theory the difference in price can be interpreted as the average expected total hike over a given period. If the 1 month rate was 12.5bp higher then that probably means there is a 50% chance of a 25bp hike given that rates have usually changed by 25bp (though who knows about the future). You can disentangle the hikes over time, but not down below the granularity of the contracts (i.e. 3 months after the first few), nor can you say wether 25bp means a 50% chance of a 50bp hike or a 100% chance of a 25hp hike.

BUT a couple of warnings:

Eurodollar is a forecast of inter bank lending rates* not the central bank policy rate. So it could be that it looks like a hike is priced in but actually it's just the credit spread that's expected to change.

Also more seriously all interest rates include both a risk premium and a forecast for what interest rates are expected to be. It's impossible to disentangle these using just the price. If you are serious about knowing expected rates you should use a survey based measure (easy to find if you have Bloomberg). There's a nice chapter in the book "Expected Returns" on this.

GAT

* well a forecast of what a bunch of guys pretend bank lending rates will be anyway

Thanks.

So at 25 bps or greater spreads imply a hike in the timeframe they capture? Less than 25 implies no hike?

What would imply a cut?

Sorry if I'm coming off a bit dense. Maybe I am.

 

[globalarbtrader]

Thanks.

So at 25 bps or greater spreads imply a hike in the timeframe they capture? Less than 25 implies no hike?

What would imply a cut?

Sorry if I'm coming off a bit dense. Maybe I am.

A 10bp spread could be interpreted as a 10/25 = 40% chance of a rise, 60% chance of no rise.

A cut would be a negative spread. Eg if the price goes from 99 to 99.5 that implies a 50bp cut.

GAT

 

[livetransmissio]

Thanks!

A 10bp spread could be interpreted as a 10/25 = 40% chance of a rise, 60% chance of no rise.

A cut would be a negative spread. Eg if the price goes from 99 to 99.5 that implies a 50bp cut.

GAT

Thanks!

What about say a butterfly?

For example EDZ6Z7Z8 trading at -2.0 bps

 

[globalarbtrader]

Thanks!

Thanks!

What about say a butterfly?

For example EDZ6Z7Z8 trading at -2.0 bps

In theory rate would go up and then down (or the other way round; I don't know what the quoting convention is). But that's probably silly. Fly spreads mostly aren't driven by bank expectations (hard core spread traders will know this is a slight simplification bit I don't want to introduce any more complexity into this post).

GAT

 

[Martinghoul]

Thanks!

Thanks!

What about say a butterfly?

For example EDZ6Z7Z8 trading at -2.0 bps

These flies are an expression of the shape of the path of rates, rather than levels.

 

[piezoe]

I understand the basic gist.

I understand that if people think they will hike EDs sell off. I also understand that LIBOR rates will track the Fed Funds rate since people would just park their money at the Fed if LIBOR is lower.

When looking at outright prices and spreads I get a bit lost.

For example EDZ6Z7 is trading 25 bps. What does that imply? 2 hikes? 12.5 bps x 2?

EDZ6 trading 99.13 right now. What does that imply apart from the expected LIBOR rate?

Thanks

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