Ask Emily: Are There Contracts That Enable Investors to Gauge Long-Term Market Sentiment?

Question:
In one of your recent columns, you explained how Fed Funds contracts may be used as a predictor of the market’s expectations for interest rate changes. You indicated that Fed Funds contracts go out 10 months. Aren’t there contracts that go out greater time periods, enabling investors to gauge long-term market sentiment?

 
 

Question:
In one of your recent columns, you explained how Fed Funds contracts may be used as a predictor of the market’s expectations for interest rate changes. You indicated that Fed Funds contracts go out 10 months. Aren’t there contracts that go out greater time periods, enabling investors to gauge long-term market sentiment?

Answer:
Yes, the Eurodollar time deposits. First, it’s important to acknowledge the definition of Eurodollar time deposits as U.S. dollars on deposits outside of the United States, where they are normally free from reserve requirements. Nonetheless, they closely track U.S. interest rates. Consequently, Eurodollar futures contracts, traditionally three-month forward contracts, are one of the most widely used fixed income contracts worldwide.

Final settlement price on a Eurodollar contract is determined using the three-month LIBOR rate after trading on the contract is completed. The quoted futures price is equal to 100 minus the annualized yield. As an example, a price of 95.50 means that investors are trading the contracts as if the three-month LIBOR rate will be 4.50% by the designated contract date.

The Eurodollar futures contracts are the underpinnings of the term markets. In other words, any given yield curve not only indicates the current cash market rates for various maturities, it too embodies forward rates. To illustrate this, assume that you have a choice of investing in a two-year security at 3%, or consecutive one-year securities at 2% and 4% respectively. Seemingly, if you invest for one year at 2% and the second year at 4%, you average 3% for two years, and it makes no difference to you. However, take it a step further. That 4%, one-year forward rate for the second year represents four, three-month forward rates. The first three-month contract might be trading low, e.g. 3%, while the fourth might be trading high, e.g. 5%, but in any case averaging 4% for one year. If the last leg is trading at 5%, it is because other investors believe that three-month rates will move up to 5% in 1.75 years. If you believe that rates will not move up this fast, then the two-year investment is your optimal investment choice. But, if you believe that rates will move up faster, then you go for the shorter term.

Where are they trading now? Well, the two-year forward Eurodollar contract was trading as low as 3.25% at the end of March 2004, but is now trading as high as 4.55%. Considering that the current three-month LIBOR rate is about 1.10%, the implication is that rates will move up between now and then by 3.45%. Market sentiment has changed dramatically in a two month time period as a result of recent economic strength.

 

 

 

June 14, 2004


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