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Tuesday, December 7, 2010

Eurodollar Futures Options With Zero/Negative Strikes!

I saw something bizarre. Other financial websites/blogs haven't mentioned this. There are some Eurodollar futures options with a zero/negative strike! More than two zero strike options have volume and open interest! (They are December and January and March 100 strike Eurodollar call options.) The other zero/negative strikes have a price quoted, but no open interest.

My employer's computers only process strikes with volume, rather than all strikes. That's a bug. If someone trades a strike for the first time, then the intraday calculations would be wrong. There's probably also a fencepost error when new options/futures/bonds are listed. The zero strike caused the program to crash. If the strike is zero/negative, then you're taking the log of a zero/negative number when you apply the Black-Scholes formula.

A Eurodollar future is a bet on what 3-month LIBOR will be in the future. LIBOR is the London dollar borrowing rate. That leads to the term "Eurodollar". However, 3 month LIBOR yield should closely track the 3 month Treasury yield. If they differed much, then some bankster would borrow in the USA and lend in London, or vice versa.

The "settlement price" is the interest rate. A price of 99 corresponds to an interest rate of 1%. A price of 98 corresponds to an interest rate of 2%. 100 corresponds to 0%. 101 corresponds to -1%. (Bond prices move the opposite sign as interest rates.) The future is cash-settled, because there's no actual underlying bond. It's based on a hypothetical 3 month bond yielding LIBOR.

One Eurodollar future corresponds to a hypothetical $1M investment. A change of 1% corresponds to $1M * 1% * 1/4 = $2500. (The 1/4 comes from "3 month" LIBOR. It's 3 months of interest on $1M at the settlement rate. There's a slight rounding error, but that's the settlement formula.)

The Eurodollar future is cash-settled based on the formula at expiration. It's based on 3 month LIBOR on settlement day. Prior to settlement, it's priced "mark-to-market" based on the futures trading price.

You can also buy Eurodollar futures options. It's an option that settles to a future when exercised. The strike is the interest rate. 99=1%, 100=0%, 101=-1%.

There was a Eurodollar futures option with a strike of 100 (0%) and nonzero volume, crashing my employer's software. If you look on the CME page (direct links to the CME website don't always work, so you may have to navigate), you can see strikes of 100 or more listed. Notice that the December 100 strike call has an "open interest" of 471. The January 100 strike call has an "open interest" of 200. The March 100 strike call has an "open interest" of 2, 801. The March 100 strike put has an "open interest" of 1 contract. Someone actually bought those calls! ("100 strike call" means "0% strike call". The option would be in-the-money only if the 3-month LIBOR rate drops below 0% on settlement day.)

How can LIBOR go below 0%? The Federal Reserve keeps the Fed Funds Rate near zero, *AND* banks get interest on reserves. If the Fed Funds Rate is 0.1% and banks get 0.25% on reserves, then LIBOR could be -0.15%. The banksters are explicitly borrowing and then lending for a guaranteed riskless profit. Only the largest banks get to make this trade, the "primary dealers". It's a stealth bank bailout.

"Primary dealers" are the biggest banks. They get the perk of borrowing directly from the Federal Reserve. A "primary dealer" might borrow directly from the Federal Reserve at 0.1%, but smaller banks might have to borrow at 0.3% on the secondary Fed Funds Rate market. With 0.25% interest on reserves, the primary dealers are getting a huge bailout that smaller banks don't get. That's a big State-granted perk for the "primary dealers". They get to borrow more cheaply than everyone else.

There were many Eurodollar futures call options that traded for a strike of 0%. That's very interesting. I didn't see any other financial blog highlight that. The Federal Reserve has lowered nominal interest rates below 0%. Remember that "real interest rates" equal "nominal interest rate" minus "true inflation". Nominal interest rates are close to 0% or even negative. Real interest rates are -20% or lower. That's a huge State subsidy to insiders. Everyone else pays the cost via inflation.

1 comment:

Anonymous said...

Why can't there be negative rates?

A rate of interest is a measure of return on capital (well, not any longer, now just on FR Points).

With real money, one does need some return, because:

a) capital is scarce
b) once loaned it is not available to the owner
c) there are risks of return OF the loan
d) if there is no return then why bother loaning?

With monopoly money one does not need any interest because:

a) there is no scarcity
b) once loaned more can be created
(or fractionaly used over and over)
c) there is no risk. see a & b.
d) one needs to loan to keep the scam rolling by inciting others to use the points.

There can absolutely be zero or negative nominal rates of interest, the bonus points being awarded for participation.

There can never be zero or negative real interest rates.

There is no end to the foolishness of the people. They will keep their money in the bank if the bank charges them an interest.

So, why not charge them? (or at least why not make nominal rate 0 by lowering the source rates below zero)? Why not?

Isn't this exactly what the people wanted when they approved one central bank after another? Don't they deserve this circus? Shouldn't there be punishment for ignoring the constitution and becoming miserable subservient creatures?

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