CME Interest Rate Options Suite

The role of options on futures in hedge fund portfolios

HAMLIN LOVELL
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The most obvious reason for the significant increase of interest in interest rate options is that “for the first time since 2008, market participants expect the Fed to move on rates. People need to hedge that risk,” says David Reif, executive director of Interest Rate Business Line Management. Various probabilities are ascribed to Fed rate rises over the next six to 18 months, but all of these probabilities are positive so ZIRP (Zero Interest Rate Policy) is envisaged to become history at some stage over the next year. CME Group products offer the liquidity, scope and breadth that is needed to take clearly defined views on interest rates.

The old adage that it takes two sides to make a market is as true as ever. Eurodollar futures open interest, tracked by the CFTC Commitment of Traders report, shows that asset managers and hedge funds seem to hold opposite positions – and the situation sharply reversed in October 2014. Asset managers have pivoted from net long to net short, while hedge funds have cut and reversed from net short to net long. These two groups together make up nearly 40% of the open interest in the contract with asset managers at 12% and hedge funds at 27%. In addition corporates, pension funds, insurance companies, endowments and foundations have a need to take views on, and hedge, interest rate exposure.

Although CME Group has no official corporate view on when the Fed will hike rates; CME Group economists regularly map out a range of scenarios and update their analysis in light of the latest economic data releases. For example in January 2015 CME Group Chief Economist Blu Putnam authored a piece entitled “the arguments for abandoning a zero rate policy”. This weighed-up arguments both for and against rate hikes to give investors some data points that could be used as inputs to form their own opinions. At that time, interest rate futures implied a 60% probability of a rate hike by June 2015, but this has been pushed further out as Janet Yellen has erred on the side of patience. Market participants can infer rate-hike probabilities for different dates, by looking at the pricing of contracts at various maturities. CME Group’s online “FedWatch” tool lets traders dynamically monitor the market’s evolving rate-change expectations, which can shift very swiftly in response to new data. For instance the May 2015 non-farm payrolls addition of 280,000 jobs led futures markets to bring forward rate-hike expectations to October from December 2015. Fedwatch is updated every 10 minutes and on June 9, 2015, the December 2015 contract factored in a 70% probability of a rate hike by December.

The most popular maturities move around with rate forecasts and CME colour-codes the first year as “whites” and the second year as “reds” with the third and fourth years being “greens” and “blues” respectively. Right now, Reif is seeing the strongest interest in the “whites” and “reds” – maturities between three months and two years ahead. This seems natural for Reif given that a rate hike is more foreseeable this year or early next year, so maturities such as September 2015 out to June 2017 are seeing heavy volumes. In contrast a few years ago, the most active products included 3-year mid curves, which reference an underlying future three years from now.

Interest rate volatility
But rate options are not just about taking directional views on rates going up or down – traders can also take views on “the greeks”. Some want to “eat theta” or earn time decay for selling options while others are seeking to monetize vega, or implied volatility and some may trade gamma.

Interest rate volatility is finally bursting out, after years of being bottled up by QE. Witness the 33 basis point intraday move in 10-year Treasury yields in 15 October 2014, which was christened “the bond flash crash”. Greece is one source of market volatility. Although the vagaries of Greek politics and bailouts might not have any direct impact on US dollar interest rates, events such as Greece – or indeed Russia, Ukraine, Iran, Syria and geopolitical factors – can be a source of general market volatility that has knock on effects on Treasuries. Europe’s bond rout since May 2015 has arguably had ripple effects for US interest rates.

Traders are making use of the breadth and versatility of the CME offering, shown in Fig.1. All CME interest rate options are listed products with defined strike prices and expiry dates. Maturities on Eurodollar options go all the way from one week out to nearly four years, filling out the interest rate curve and giving lots of alternatives for trading. “Compared with most listed options, Eurodollars often have a very long maturity profile,” says Reif. Treasury options mirror the maturities of the Treasury Futures CME Group offers: 2, 5 and 10-year contracts are complemented by the bond (between 15 and 25 years) and “ultra” (more than 25 years remaining) contracts. The options traded are American style and can be calls or puts. Some traders are using Treasury as well as Eurodollar options to construct calendar spreads and conditional-curve trades that could profit from a steepening, flattening or inversion of the yield curve. Mid-curve options, with three or six months to expiry, are also being used for calendar plays. Others are using the options to express views on volatility at various points of the curve. All of the classic option structures, such as straddles, strangles, butterflies, condors, call spreads and put spreads and combinations thereof can be created, and online tools – programmed with the relevant ratios – assist with trade construction.

Arbitrage and hedging
There are also opportunities for arbitrage and hedging between futures and OTC markets and the new RapidRV tool introduced in March 2015 is a powerful resource for relative-value traders. It lets market participants carry out real-time market data and analytics while on the move. This cloud-based system using technology from The Beast Apps Group allows traders to identify relative-value and arbitrage opportunities between OTC and exchange-based futures markets. Live futures prices for CBOT Deliverable Swap Futures, CME Eurodollar Futures and CBOT US Treasury Futures coming from CME and OTC quotes (for Interest Rate Swaps and US Treasuries) are streamed from ICAP Information Services. Hedge ratios and cheapest to deliver calculations are done instantly and automatically, providing the building blocks for both hedging and arbitrage strategies.

Trading Costs
Many traders find that the CMEGroup interest rate product suite offers competitive costs. When it comes to trading and transactions costs, CME likes to help traders make an informed choice because “each trader faces different constraints, so it’s hard to say which product is best.” Reif explains. CME is committed to helping the market conduct thorough cost-benefit analysis. Greenwich Associates has carried out a study called “Total Cost Analysis of Interest Rate Swaps vs Futures” looking at cost of trading, including liquidity, typical fees and bid-ask spreads. The study concluded that futures would tend to have lower trading costs than swaps, based on the liquidity available and margin efficiencies.

Says Reif, “Margin efficiencies are one of the benefits of trading on the CME Group.” CME Group offers cross-margining between listed products, and offers total-cost analysis tools that let traders weigh up the variables. For instance the Margin Optimiser online tool will let traders calculate optimal combinations of contracts to minimize margin. Margin offsets can be as high as 100% for Eurodollar Bundle Futures, and there is allowance for offsets between interest rate futures and options products. Eurodollar contract margins can also be offset against Deliverable Swap Futures. CME Group’s rate options are margined based on one-day scenarios, whereas OTC options will be subject to higher constraints under new Basel III standards.

The Greenwich study does acknowledge that some participants might be willing to pay more for greater customization that OTC products offer, but CME Group itself is constantly striving to make its offering more flexible and granular. “We are always looking at product extensions,” says Reif.

Adding weekly Treasury options in 2011, with expiries each Friday, has proven to be a huge success. The contract trades over 80,000 lots per day and has provided tremendous flexibility in structuring options trades. This illustrates how CME refines product offerings to meet market demand. Last year CME introduced listed options on the Eurodollar “bundle” which is a strip comprised of quarterly Eurodollar contracts. The option is on the average price of the outright futures, resembling an exchange-traded version of swaption exposure. Going forward, CME has received regulatory approval for clearing OTC swaptions and is “working towards implementation, actively engaging market participants,” says Reif.