Eurodollar futures not reflecting yield curve?

P

panaceus

How is it that the average yield of the 3-month LIBOR (.26) and the October Eurodollar future (.415) is so much less than the 6-month LIBOR (0.43) ? Shouldn't arbitrageurs ensure that those are quite close, by making the 6-month investment and selling the (3 month investment + Oct. future)?

I have no doubt there's a simple explanation, but I'm baffled.
 
Well, think about it for a sec - which one has more credit risk, 6m deposit or 3m deposit plus a 3mx3m forward rate lock....
 
This is the wonder of the post-crisis rates mkts... There's a thing called 3s6s basis. The presence of this basis implies that the fwd rate equality doesn't hold for rates with a different underlying term. Therefore, you can't recover the 6m mkt rate from a combination of the 3m and the 3m 3m fwd mkt rates.

The reasons for the presence of the basis are twofold:
1) As sle mentioned, different counterparty default risk
2) Different liquidity characteristics of lending for different terms

What this means is that the CME doc is woefully out of date. To be sure, it was never right in the first place, but everyone chose to ignore the pesky "term" issues. In the brave new post-crisis world, they can't be ignored any more.
 
The most relevant item on this that I could find was here: http://uk.reuters.com/article/2010/03/12/holdmarkets-money-idUKLDE62B0QF20100312

It says:

"During the financial crisis, as money markets dried up,
6-month rates rose more sharply than 3-month rates due to a lack
of lenders willing to lend longer-term, leaving those with swap
contracts paying 6-month Euribor -- the most liquid area of the
swaps market -- facing soaring costs.

An overhang from that is that many corporate issuers, having
swapped fixed-rate bond liabilities against a 6-month floating
rate, now swap again, aligning their borrowing costs with
3-month Euribor and pushing up the basis."

Is the liquidity under discussion a direct consequence of the increased counterparty risk, or something separate?

Also, and this may be wholly unrelated, why is the 1-year LIBOR curve so much steeper than the 1-year Euribor curve? Something to do with Fed lending?
 
I mentioned the two factors that influence the term basis above. Counterparty risk is just one of them.

As to the "1y LIBOR vs 1y Euribor" you need to be careful about your terminology. Are you referring to the two contract strips and the fwd curves they represent? If so, it's mostly a matter of the mkt's view on the different macroeconomic dynamics in the US and the Eurozone and their implications on the CBs' actions.
 
Sorry, I should have been clearer. I couldn't unravel those two ideas (counterparty risk and liquidity characteristics) in the piece I linked. By liquidity characteristics, do you mean the relative ease of unwinding the positions?

As for the 1y LIBOR vs 1y Euribor, I believe I am referring to, as you said, the contract strips and the fwd curves they represent (for instance the June 2011 row at the bottom of this page: http://www.wsjprimerate.us/libor/libor_rates_history.htm , which has a markedly different appearance than the Dec. 2008 row).

I see that in another thread you've just recommended a few resources on bond trading in general. Which of those would be best for understanding how Fed policy, market dynamics, and the LIBOR forward curve interact? The Ilmanen papers? Thanks!
 
Yeah, they would definitely help with the theory, but keep in mind that they're older classics. For factors that generally influence the shapes of these curves, definitely do read Ilmanen's papers, as they're, by far, the best introduction to these subjects.

In terms of the LIBOR term basis, just imagine yourself as a lender. What two things matter to you the most when you lend money? Obviously, one concern is counterparty risk. The other issue is that you might need the money yourself, which means that you're going to be more reluctant to lend for a longer term. The counterparty risk issue is reasonably well understood and there's all sorts of models that account for it. The other risk, which is what I was referring to as a "liquidity" issue, is a much harder problem to deal with.
 
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