Hedging Mortgage Rates with Eurodollar Futures
by Michael Marshall
Learn how to lock in an interest rate for your mortgage at today low levels without refinancing your home.
With mortgage delinquencies at all time highs and ever-tightening lending standards, re-financing a mortgage can, for some, be an unachievable task. This article will briefly attempt to describe a way that an investor could “lock in” an interest rate on their current loan through a strategic hedge in a short-term interest rates market. From my experience, the market of choice for this type of hedge position would be the Eurodollar futures, traded at CME Group.
Both the Federal funds rate and LIBOR (London Interbank Offered Rate) are short-term lending rates. As you can see from the historical chart above, the Fed funds rate and the one-month LIBOR tend to move in tandem.
The Eurodollar futures are quoted on an index basis, 100 minus the LIBOR. Since LIBOR is the base rate that is used on most adjustable rate mortgages (ARMs), this makes it the ideal market for a rate hedge on an ARM loan. Moreover, Eurodollar futures are extremely liquid, even in contracts far out in time.
LIBOR is influenced by the Fed funds rate, but LIBOR can differ based on how the European Central Bank views its lending risks over and above its knowledge of what the U.S. Federal Reserve is doing. Because LIBOR rate changes can differ from Fed rate decisions, I cannot stress enough that a qualified, and experienced advisor should help you when establishing your hedge. While there is a strong correlation in short-term rates, as noted, it isn’t always perfect.
Hedging Strategy
By my calculations, a one percent increase in interest rates on a $250,000 mortgage would yield an increase of $2,500. Since a Eurodollar point is valued at $2,500, the hedge should be pretty simple. For every $250,000 of your mortgage, an opposing hedge of one contract should allow you to “lock in” an interest rate for your mortgage at today’s currently low levels. So you’d take a short position in as many Eurodollar futures as you need to cover the one percent rate increase.
Though volatility on the Eurodollars is low relative to many futures markets, prices do react to the perceived need for rate changes. For instance, news that the economy is weakening and that further rate cuts may be needed would likely push the Eurodollars higher. For this reason, the Eurodollars are more volatile than the Fed funds rate futures. Eurodollars are also substantially more liquid than the Fed funds rate futures as well. These two reasons make the Eurodollars ideal for taking advantage of future rate hikes. Current volatility should allow us the chance to sell a rally and enter into a relatively low-risk trade, while liquidity will allow us to enter trades well into the back months with the risks of trading a thin market. Of course, if rates don’t increase, or start heading lower due to some unknown financial crisis, you would face risk of loss on your futures positions. Again, I can’t stress enough the importance of working with a professional.
Every investor has a different and unique risk tolerance. You can even consider options strategies if you’d like to define your risk. Mitigating factors for this type of strategy prevent me from giving a specific recommendation for a position of this sort. Risk tolerance, size of hedge and available risk capital are all factors to be taken into account when looking at this trade. Let us tailor a strategy to fit you’re your needs. One that will allow you to protect your mortgage against future Fed rate hikes.
Mike Marshall is a Market Strategist with Lind Plus, Lind-Waldock’s broker-assisted division. He can be reached at 800-437-4189 or via email at mmarshall@lind-waldock.com.
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