November 15, 2018
Using Eurodollar interest rate options to hedge your portfolio
The US economy has been growing strongly, producing jobs and rising wages. All good things must come to an end and there are plenty of reasonable arguments why the accompanying stock market rally could be on its last legs. Investing is about judging the probabilities and allocating accordingly. The stock market has been volatile lately, but the S&P 500 was still up about 6.5% for the previous 12 months as of mid-November. For fully invested portfolios, there is plenty to lose if the economy rolls over and the stock market follows. Hedging is always difficult and usually an expensive trade off. Stock index put options tend to be very expensive. US Treasury bonds have been an excellent diversifier for stocks but this relationship may be faltering if higher rates are the cause of a bear market. This post will present a solution using Eurodollar futures options which track U.S. short term interest rates.
If the economy abruptly begins to slow down, recent history has shown, the Fed is likely to start easing short term interest rates aggressively. Greenspan firmly established that the Fed should do everything in its power to avoid the pain of recessions. In fact, one the reasons the Fed wants to raise rates now is, so they can lower them later when there is a recession. Therefore, there could be value in placing hedges designed to profit based on the assumption that the will Fed lower short term rates if signs of a recession emerge. There are many ways to place trades that will benefit from lower short term rates, but we are looking for something inexpensive to avoid burning too much cash on hedges if nothing happens (hedges are a form of insurance, you pay for but hope it is never used). The most practical way to place this interest rate hedge is focus on Eurodollars which are a close proxy for US short-term interest rates.
Eurodollars, in this case, do not refer to the European currency but rather US Dollar bank deposits held in foreign banks (traditionally in Europe, hence the name). These foreign-based US Dollars can be borrowed from the banks at an interest rate (called LIBOR) that usually tracks the interest rates set by the US Central Bank (Fed Fund rate) very closely. The chart below shows how tightly the LIBOR and Fed Fund rates have tracked each other.
Therefore, if we can buy options based on the LIBOR rate which closing follows changes in the Fed’s interest rates, we can create the desired hedge. Eurodollars only trade as a futures contract, so one needs to have the access to an account that trades futures and futures options. Even though futures trading is not appropriate or desirable for many investors, buying limited numbers of options that have a defined risk of their purchase price does not have to be risky. The leverage and margin issues associated with outright futures contracts themselves are avoided.
Eurodollar futures are a simple construct. The trading price is based on the 3-month LIBOR interest rate subtracted from 100. For example, on November 15, 2018, the 3-month LIBOR interest rate was 2.64% the Eurodollar futures price (Nov 18 contract) contract closed at 97.35 which implies an interest rate of 2.65%. If short-term interest rates suddenly went down 0.50% tomorrow, the Eurodollar contract should immediately increase by 0.50 in price. Remember, 100 represents interest rates of zero, so when rates go lower the Eurodollar price goes higher.
There are plenty of time periods to choose from with Eurodollar futures contracts maturing every quarter out over the next 10 years. For our purposes, the next year or so is good enough. We just want to hedge a recession coming by the end of next year. If things are still rosy, we can choose to hedge again for another year. This is usually cheaper and more effective than trying to hedge using longer dated contracts from the start.
The very close in time contracts will tend to reflect almost exactly the current LIBOR rate (in turn the Fed Funds rate) in price. Contracts further out in time will reflect the market's expectations for changes in rates during that time period. For example, the Eurodollar contract based on December 2019 is now priced now at 96.93. This implies a future interest rate of 3.07%, or 3 more 0.25% rate hikes (the extra .07 suggests the market's group view that there is a slight chance for more). Now what happens if the economy turns down and Fed instead decides to lower rates from the current 2.25 to 2. This equates to a Eurodollar price of 98 (100 – 2) which would mean an increase from the current price of about 97 to 98. The market might even reverse its "group think" and instead of start to anticipate even more cuts before the end of the year and push the Eurodollar price up even higher, maybe 99, thereby predicting future Fed short-term rates falling to 1% from the newly established Fed rate of 2%.
A very simple strategy is to buy call options based on this December 2019 Eurodollar contract. If the economy slows and Fed drops interest rates in a meaningful way, the December contract should increase in price. For a call option with a strike price of 98 and the Eurodollar price is 99, the option should be worth about 1. That does not sound like much, but the contracts are based on $1M, so each 1 point works out to be $2,500. In this example, only two call options would be enough to cover a $100,000 portfolio for a 5% loss. How much would this option hedge cost, as of November 16, 2018, the December 2019 calls with a 98 strike price closed at a price of 0.0275 which equates to $68.75 ($2500 x 0.0275). Buying two would cost $137.50 (plus commission) which would mean the hedging expense would only cost 0.1375% for a $100,000 portfolio.
If there is a recession and the Fed does lower interest rates, how much and when will depend on how well this hedge performs. If the Fed increases rates to 3.0%, as most expect, it would take a lot for rates to then be reversed all the way to 1.0% by the end of next year. Here is a chart of the recent path of Fed policy rates.
Rates were less than 1% back a few years ago, so it is not inconceivable they could be back there again if the economy slowed sharply. If rates come down to 1.5% instead of 1%, the December 98 call in the previous example at final expiration should be worth 0.50; 100-1.5 = 98.5 which implies a value of 0.5 since the index price of 98.5 is 0.5 above the call strike price of 98. This price of 0.5 x the contract point value of $2500 = $1,250 each or $2,500 for two. This would cover a loss of 2.5% of a $100K portfolio. Here is a table showing the theoretical final value of one December 2019, 98 strike call option at expiration based on various future Fed Funds rates (really LIBOR, this also assumes they will closely track each other):
There are many other options to choose from that will change the time frame and the sensitivity to interest rate moves. Here is how the numbers work out for the same December 2019 time frame but a more expensive 97.5 call strike price, currently trading at about .075 points or $187.50 each.
Two 97.5 calls would cost $350 or 0.35% to hedge $100,000 portfolio, a bit more expensive but increase the potential payoff of the hedge.
Timing the next recession is nearly impossible, therefore using inexpensive Eurodollar options as a hedge instead is appealing. The lower-cost means the hedge can be maintained longer with less total cash outlay (assuming pricing stays similar to now). All of the specific options presented here are for example purposes only, they are not trade suggestions. If you are new to futures and options, getting professional advice would be sensible (be sure to the commission costs are kept to a minimum though). A big part of investing success is playing the odds since no one is able to consistently predict every next move in the markets. At this late stage of the stock market bull market, an inexpensive hedge seems like a good idea.
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