Christian Schaller - SOFR Futures and Options: A Practitioners Guide

1. Chapter 2
2. Chapter 3
3. Chapter 4
4. Chapter 5
5. Chapter 6
6. Chapter 7
7. Chapter 8
8. Chapter 9
9. Chapter 10

1. Chapter 1
2. Chapter 2
3. Chapter 3
4. Chapter 4
5. Chapter 5
6. Chapter 6
7. Chapter 7
8. Chapter 8
9. Chapter 9
10. Chapter 10

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DOUG HUGGINS

CHRISTIAN SCHALLER

Copyright 2022 by Doug Huggins and Christian Schaller. All rights reserved.

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ISBN 9781119888949 (Hardback)
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ISBN 9781119888956 (epub)

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by Galen Burghardt

February 2022

Writing this foreword is a little like writing an obituary for a dear friend. LIBOR, and the Eurodollar futures and options contracts that have been tied to it for nearly 40 years, will be put to bed soon. And so ends a remarkable era of financial innovation that transformed the world of interest rate risk management and academic research.

Still, if you're reading this Foreword, chances are that SOFR, and its related futures and options contracts, have made the competitive cut and are serving as replacements for my old friends. So let's spend the next few paragraphs reflecting on what we've learned.

I think I can be most helpful by recounting some of the reasons the Eurodollar futures contract helped to revolutionize the world of banking and finance. And by finance, I mean both applied and academic.

First, it's worth remembering that at the time Eurodollar futures were first listed in the 1980s, there had never been a futures contract that cash settled to an abstract concept. In talking with Rick Kilcollin, who was largely responsible for the contract's design, I learned that the LIBOR market in the early 1980s was thin, and that the development of an index that could capture a relevant financing rate and resist attempts at manipulation was still unfinished. With that in mind, what the Chicago Mercantile Exchange (CME) devised was an ingenious survey in which banks of whatever credit rating were not asked what rate they were paying for interbank funds in London. Instead, they were asked to provide the rate at which they perceived funds were offered to prime quality banks. This, combined with the practice of throwing out the high and low responses, produced a survey outcome with an astonishing degree of agreement.

Second, it's worth remembering that when the contracts were first listed, they were the runty cousins of the certificate of deposit contract. A special, and less expensive, membership was created by the CME for trading the contract, which took place in a small corner of the CD pit. I may have made up this story, but I recall someone saying that Fred Arditti, who was the CME's head of research at the time, would visit the pit each day and come back saying, I die a little each day when I see how little is going on there.

Then all hell broke loose. Continental Illinois, whose CDs were deliverable into the CD futures contract (and whose motto was We will find a way) suffered some substantial loan losses and took a hit to its credit rating. It didn't take long for the market to start worrying about credit risk in the deliverable instrument and to look elsewhere.

At the same time, the interest rate swaps market was beginning to take hold and grow, and the Eurodollar futures market was poised perfectly to go along for the ride.

Eurodollar futures proved to be a financial engineer's dream tool. In the 1980s, the idea of zero-coupon bonds was largely found in textbooks. As was the idea that one could break up the yield curve into three-month (3M) segments and use those segments to study yield curve behavior and the sensitivity of one's financial position to each of those segments.