Forecasting Rates Months Into The Future Using Eurodollars
In an earlier lesson, I described how to use the federal funds futures
contract to forecast changes in the federal funds interest rate, the most
powerful weapon in the Federal Reserve’s monetary arsenal. The contract works well for assessing market expectations for near-term changes in this key interest rate. But for
handicapping rates months into the future, professionals look to eurodollar
futures.
If you haven’t done so already, check out my lesson
The Fed With Fed Funds Futures. In summary, the fed funds rate set by
the Federal Open Market Committee determines the overnight lending rate
that banks charge each other for loans of excess reserves. Lowering the rate
stimulates bank lending and, thus, economic activity — raising the rate
accomplishes the opposite.
When trying to get a handle on the
probable rate-setting outcome of an upcoming FOMC, one uses the fed funds futures
contract. However, open interest and volume in the fed funds contracts fall to meager levels
for contracts expiring in the months further out. This makes pricing too
volatile to render statistically reliable forecast data.
Eurodollar contracts, however, have
ample open interest. In fact, eurodollar futures are the most actively traded contracts in the world. At the time I’m writing this lesson, there are
3.3
million eurodollar contracts outstanding vs. 45,400 fed funds contracts. Thanks
to this enormous liquidity, we can trust that the daily settlement prices in
eurodollar contracts accurately reflect the market’s assumptions about the
future level of the fed funds rate.
Eurodollars are U.S. currency held in
non-U.S. banks, European or otherwise. For example, U.S. dollars deposited in a
Hong Kong bank are eurodollars. Thanks to the dollar’s status as the world
reserve currency, eurodollars are commonly used to settle international
transactions.
When you want to forecast the likely fed funds rate that will prevail after
the next FOMC meeting, you calculate the implied yield
of the fed funds futures contract for that or the following month (depending on
factors detailed in my previous lesson). When you want to forecast the fed funds
rate for some time many months in the future, you look at an adjusted
implied yield of the eurodollar contract for that point in time.
There’s a fed funds contract for every month in the year. In other words, the
September fed funds contract represents the market’s best guess at the
prevailing fed funds rate for that month. Eurodollar contracts span quarters,
except for near-term months, which also have open contracts. So
the adjusted implied yield of the December eurodollar contract would represent
the market’s consensus forecast for the fed funds rate in the month that the
contract expires.Â
The ticker symbol for the eurodollar
contract is ED, followed by the letter designating the expiration month of the
contract and the number designating the contract year. March is
represented by the letter H, June by M, September by U and December by Z. The
year symbol is simply the last digit of the year. For instance, the year 2001
would be 1. So the March 2001 contract would have the ticker EDH1.
Adjusting The
Implied Yield
Okay, I’ve said that we must adjust
the implied yield of the eurodollar contract in order to divine the market’s fed
funds rate consensus for the contract quarter. What are we adjusting for? Loans
of foreign-deposited dollars carry a higher interest rate than
loans of dollars deposited in U.S. banks. We need to factor out this premium
to get at the implied yield reflecting the fed funds rate assumption priced into
the contract.Â
To do so, we turn to the London
Interbank Offered Rate, better known as LIBOR. The LIBOR represents the rate
that creditworthy international banks charge each other for loans of
eurodollars. The spread between the three-month LIBOR and fed funds rate represents the
premium that we want to subtract from the implied yield of the eurodollar
contract.
Let’s say that the LIBOR stands at
6.66%, a spread of 16 basis points above the fed funds rate of 6.50% at the time
I’m writing this lesson. We’re interested the market’s assessment of where the
fed funds interest rate will stand in the quarter ending March 2001. Assume that
the March 2001 eurodollar contract settled at 93.33. That gives an implied yield of
6.67% (100 – 93.33). Now subtract the LIBOR-fed funds spread of 16 basis points. This adjusts the implied yield to 6.51%. So the market is pricing in only one basis point of tightening. In other words,
the market assumes a very high probability that the Federal Reserve will not
raise rates between now and March 2001.
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