Profiting From Convergence
by Ira G. Kawaller
Here are three ways to capitalize on the property of convergence — the fact that futures prices and spot
prices will necessarily come together at the futures expiration. The same concept can be applied to many
markets, including various other financial futures contracts, as well as assorted hard commodities.
LIBOR (London interbank offered rate) futures contracts are recognized as Chicago Mercantile
Exchange (CME) contracts that pertain to a $3 million one-month Eurodollar time deposit, and the
Eurodollar futures contract refers to the contract with a $1 million face value, three-month Eurodollar
deposit. The convention is unfortunate, as both contracts are used to lock in the offered rates of the
respective terms to maturity. When LIBOR futures prices reflect interest rates substantially different from
underlying spot (cash) market interest rates, attractive trades may be available, and they may persist for
reasonably extended periods of time.
Consider the situation: On October 7, 1991, the spot price for the LIBOR on one-month Eurodollar
deposits was 5-1/4%, which converts to an International Monetary Market (IMM) index price of
100.00-5.25, or 94.75. On the same date, the December futures settled at a price of 94.20. With neutral or
bullish tendencies (expecting interest rates to stay the same or fall), these conditions were very attractive.
Not only could a trader make money on a spot market move, but the basis would further enhance profits
by 55 basis points (94.75-94.20) per contract. Of course, the trader could make an incorrect assumption
about interest rates and see them rise instead of fall; but even here, the error would be cushioned by a
55-basis-point safety net.