V.10:2 (52-54): Profiting From Convergence by Ira G. Kawaller

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 THIS

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.