The majority of today’s investors are not happy with the current bear market conditions affecting the stock market.  Nevertheless, many remain in the markets looking for potential investment opportunities that await.  Some traders seek opportunities in markets that have the ability to be more stable and conventional.  Recently we have identified a trading opportunity that we feel possesses a potential for return: The Eurodollar Market.  Investors should be aware that trading futures and options involves substantial risk of loss and is not suitable for all investors.  

EURODOLLAR MARKET

The Eurodollar is a short-term financial instrument similar to a T-Bill.  Typically, it is mistaken for Euro Currency, which is comprised of the numerous official currencies of the European Union.  The Eurodollar is a 90-day interest bearing note, denominated in US dollars and held in European banks.   More importantly, it is an interest rate predictor for the U.S. short-term rate (also known as the Fed Funds Rate) and the London Interbank Offered Rate, or LIBOR rate.  As a general rule the Eurodollar has an inverse relationship with U.S. short-term interest rate and the LIBOR.  Typically when U.S. short-term rates and the LIBOR go up, the Eurodollar goes down.

U.S. SHORT TERM RATES

We believe that there are several factors that may lead to interest rates rising later this year.  Trying to bolster a suffering economy, the Federal Reserve has severely decreased the value of the dollar by the series of interest rate cuts between September and April.  Unfortunately, what this has done is contributed to severe inflation.  One market analyst from SunTrust bank, Andrew Richman stated, “The Fed has done what they can and have gone maybe a little bit too far in lowering rates, where inflation is a bigger concern than lack of growth.''  The Open Market Committee recently stated that it still foresees a threat of rising prices and stated that they "will continue to monitor inflation developments carefully.”  Reductions in interest rates are thought to typically coincide with higher inflation.  After the election we believe that the Federal Reserve is likely to begin to raise the rates again to try to ease inflation.  Most investors expect the Fed to raise the benchmark U.S. interest rate at least a quarter-point by year-end of 2008.  

Accelerating inflation has caused U.S. consumer prices to surge substantially.  Surging prices are adding to further speculation the Fed will raise rates even with the substantial problem of the credit catastrophe still lingering.  Ben Bernanke recently stated in congressional testimony that there are “significant downside risks to the outlook for growth,” and “upside risks to the inflation outlook have intensified.”  A Reuters/University of Michigan survey recently reported that the average American household can foresee an average annual inflation of 3.4 % over the next five years, the highest expectation since 1995.  

Philadelphia Fed President Charles Plosser said July 22 the central bank should raise rates “sooner rather than later” to prevent inflation expectations from getting out of control.  “If we remain overly accommodative in the face of these large relative price shocks to energy and other commodities, we will ensure that they will translate into more broad-based inflation that -- once ingrained in expectations -- will be very difficult to undo,” Plosser said.  “I believe we must and will take the appropriate steps to ensure that does not happen.”  Richard DeKaser, chief economist at National City Corporation said Plosser’s position today is “not necessarily reflective” of the broader group of Fed policy makers.  He continued to state that, “inflationary risks have risen, and they want to start laying the ground for eventual rate hikes to come.”  Also in agreement with Plosser is Minneapolis Fed President Gary Stern.  He stated on July 18 “that policy makers shouldn't wait for financial and housing markets to stabilize before raising rates.”

THE LIBOR RATE

The British Bankers' Association’s (BBA) London Interbank Offered Rate (or LIBOR) is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market (or interbank market).  The LIBOR closely reflects the real rates of interest being used by the world's big financial institutions.  The LIBOR rate is used as a benchmark to set rates for financial products worth around 350 trillion U.S. dollars.  The four major LIBOR currencies are US Dollar, Sterling, Euro and Yen, but the recent commentary has been primarily in respect of Dollar LIBOR. Which some institutions (primarily European) consider that the current US Dollar LIBOR fix can be too low, others (primarily US) consider it can be too high.

The BBA recently announced that it will implement changes to the authority of its LIBOR.  The proposed changes include tighter scrutiny of the rates contributed by banks, which means individual contributing banks will have to justify any discrepancies in the rates.  The BBA is also calling for an increase in the numbers of contributors to some of the rate-setting panels, as well as wider membership of the Foreign Exchange and Money Markets Committee, the independent body which oversees the process.  “These changes will further strengthen BBA LIBOR and the confidence of its many users,” said BBA chief executive Angela Knight.

Figure 1.0 illustrates the inverse relationship of the Eurodollar and the LIBOR markets.

TRADING RECOMMENDATION

A bearish play on the Eurodollar market suggests the anticipation of the U.S. short-term interest rate and the LIBOR rate rising.  Typically, the longer-term Eurodollar options will generally react a lot more than the front months because the awareness should be that the Fed would continue raising rates in the future.  Please be advised that the risk of loss in futures and options trading is substantial.  Past performance is not indicative of future results.  All known events have already been factored into the underlying commodities.

Trade Recommendation:

June 2009 Eurodollar Bear Call Credit Spread 
    - Buy 9625 call and Sell 9600 call for a credit of 19 points ($475)
        - Profit Potential: Credit collected (less commission and fees)
        - Risk: $150 + $70 (commission and fees)

June 2009 Eurodollar Put
    - Buy 9550 put for 8 points ($200)
        - Profit Potential: Unlimited
        - Risk: $200 + $70 (commission and fees)


Questions or Comments:
Christine London
Option Investments Inc.
800-900-8000 ext: 210
www.OpVest.com