Historically low interest rates, coupled with uncertainty about their future movement, have led to demand for finer strike increments for short term interest rate options.
Reducing strike increments and increasing the number of available prices in the front Eurodollar and Three-Month SOFR options will allow finer hedging in nearby rate movement.
Target rate cuts by the FOMC in 2019 and 2020 pushed the effective federal funds rate back to historic lows. Associated short-term interest rates including ICE LIBOR and SOFR followed to near zero levels. However, the uncertainty of when and by how much rates will move has created demand for options with finer gradations, allowing market participants to fine-tune price points. In November 2020, CME Group will tighten the minimum increment between strikes.
For options on Eurodollars futures, this will include the Serial and Quarterly Three-Month contracts, beginning with the December 2020 quarterly listing. For SOFR options, the Three-Month contracts will be aligned with the One-Month, also starting with the December 2020 listing.
In both cases, the lead months currently have strike listings spaced 12.5 basis points apart within 150 bps of the futures prices, with 25 bps spacing outside of that range. Following the change, the front month contracts will see their strike listings reduced to 6.25 bps apart, with later expiries remaining 12.5 or 25 bps apart as they are currently.
A Clearing Advisory Notice and Special Executive Report have been published detailing technical details, including the standardization of implied decimal pricing and locator:
As with many futures contracts, hedging in Eurodollar options on futures is concentrated in the nearest expiries. Historically, it was not uncommon for 50% or more of overall activity to take place in the nearest six contracts (two quarterlies and four serials). However, surrounding the FOMC rate cuts of fall 2019 and spring 2020, the share of average daily volume in the first six contracts rose above 80%, and open interest reached 60-70%.
Even after this share retreated from event-driven highs, it remained above 60%, even though the Federal Reserve had given guidance on its short- and medium-term policy plans. In other words, even with fairly high confidence in overall effective ranges in the near future, market participants have at least as much concern over specific rate levels during that time period as they do over the larger, policy-driven moves (e.g. 25-50bps hikes) expected further in the future.
Source: CME Group
As a measure of secured financing not subject to credit spread gyrations, SOFR is likely to remain near the effective Fed Funds rate, but with a significantly larger transaction base than for Fed Funds (typically 15-20x), it makes sense that market participants desire optionality on its finer movements. Thus, for both contracts it makes sense to reduce the strike increments to match those of the shortest-term rates products.
Within the bounds set by Federal Reserve rate policy, SOFR exhibits daily volatility proportional to its outright rate. Throughout 2019, this meant considerable movement across the 12.5 and even 25 basis point intervals for which strikes are available. This can be seen in Exhibit 2 below, with 25 bps intervals in blue and 12.5 bps divisions between them in gray:
The March 2020 FOMC rate cuts saw SOFR follow the effective Federal Funds rate below 25 basis points. While daily volatility in rates persisted, it was at a smaller scale which left the strike intervals coarse by comparison. In Exhibit 3 below, blue lines indicate the 12.5 basis point levels, which daily SOFR levels only cross a few times. The 6.25 basis point divisions, shown in gray, are a finer risk management tool enabling market participants to dial in tighter expectations.