Spreads in financial futures markets: Treasury bill and Eurodollar futures

Abstract

Financial futures are used by market participants for both hedging and speculative reasons. Financial futures spreads provide investors with the opportunity to profit by predicting relative price moves between two futures contracts.

This dissertation is a theoretical and empirical examination of the spread between Treasury bill and Eurodollar futures, known as the TED spread. Theoretical differences between Treasury bill and Eurodollar futures contracts are considered to determine factors which should affect the magnitude of the TED spread. Theory predicts that the magnitude of the TED spread should be influenced by default risk on Eurodollar CDs, the difference in yield quotation conventions between the two contracts, tax effects, reserve requirements, and the fact that Treasury bill futures settle to price while Eurodollar futures settle to yield.

Empirically, the impact of reserve requirements, the differential yield conventions, and the fact that Treasury bill futures settle to price while Eurodollar futures settle to yield, are tested to determine their impact upon the TED spread. The impact of reserve requirements is tested by comparing the competing hypotheses of Fabozzi and Thurston (1986) with that of Fama (1985) and James (1987). The results are consistent with Fama and James finding that Eurodollar CD reserve requirement changes do not have a significant impact upon the magnitude of the TED spread.

Treasury bill futures prices are quoted on a discount yield basis, while Eurodollar futures prices are quoted on an add-on yield basis. Theoretically this difference should cause the magnitude of the TED spread to increase when interest rates are high and decrease when rates are low. Wlien considered in a long-run equilibrium framework, we find no evidence that the differential yield conventions have a significant impact upon the magnitude of the TED spread.

Sundaresan (1991) predicts that the differential settlement procedures in the Treasury bill and Eurodollar futures market should cause Eurodollar futures prices to be higher holding other factors constant. We adapt this theory so as to test it within the context of the TED spread. The results indicate that differential settlement conventions have a significant impact upon the magnitude of the TED spread, however, this effect is not as pronounced as predicted by the theory of Sundaresan.