Our Eurodollar Trade - Back Again

Back in February of 2021, we wrote a brief note about one of our favourite instruments: the Eurodollar futures option. Now, we return back to the trade.

‍

How do you go levered long without debt?

This is a question we ask ourselves all the time. Leverage magnifies returns, but has a nasty habit over longer time spans to present existential risks to portfolio at worst, or usually undo a lot of the upside garnered with it.

The ideal course of action is to find things that *mimic* the upside effect of leverage, cutting its problematic downside behaviour over time.

This is our eternal search for upside convexity, and the more usual instrument we look out are options. This is because:

• They allow construction of relatively precise investment thesis.
• They are often mis-priced in various directions.
• The mis-pricing gets more pronounced as market conditions become more chaotic.

You can get a lot of implied leverage to the upside, cutting the downside exposure on vanilla instruments like stocks. However, when the instrument is itself a derivative of an other instrument, the convexity goes through the roof. This is particularly true of futures.

In particular, one family of futures: Eurodollar.

‍

Eurodollars

Eurodollar rates are the going interest for deposits of U.S. dollar-denominated deposits at foreign banks or at the overseas branches of American banks. In essence, they represent the US Federal Reserve funds rate. Futures on the eurodollar rate, represent expectations of future fed funds rates. Options on futures are, needless to say, volatile:

• They are driven by a single event
• Expectations on those events can change very fast
• They are relatively illiquid and obscure

In other words, bingo for what we look for in a convex instrument.

‍

The Trade

Back in 2019, we went long eurodollar futures calls, with the expectations that the federal reserve would have to cut rates based on slowing macro indicators. Of course, providence helped us and they had to cut *a lot*. Now, we are in a situation where the expectations is a cumulative raise of 121.25 bps by the end of the year, followed by a cut of 40 bps for 2023.

Needless to say, we believe the Fed will have to cut a lot more than that, perhaps a lot faster than expected.

The trade is now back on again: we are long a ladder of maturities and strike betting on fed cuts over the next 18 months.

‍

Pleas see our original note, originally written 02/02/2021:

Macro and convexity: Eurodollar Trade in 2019-2020

‍

As the leading macro indicators of financial health were rolling over in early 2019, a trade was needed which could deliver a strong amount of alpha, whilst simultaneously hedging a long book against tail edge market corrections and crashes. The end choice was a relatively long dated call ladder on Eurodollar Futures. 

‍

It was identified that in case of a market correction, the central banks would have to shore up the system with liquidity by slamming down short term rates towards the zero bound. Unlike far out of the money puts, with a substantial cost of carry and theta decay, Eurodollar market was not pricing a reduction of interest rates past an “ordinary” correction to extend the cycle. 

‍

This meant that a group of options on futures could be had for very cheap. This also meant that this position had an extremely attractive implied leverage. Not only was leverage embedded in the futures themselves, but the options gave convex upside and limited downside. Even if the tail end event did not materialize, there was an array of macroeconomic and microeconomic research that supported the longer term trends of lower interest rates, which lent some support to the price action. The ladder of options presented a return profile ranging from 20% to 300%.

‍