When we look back at the credit crisis of 2007, it is possible that the first week in August will be noted as a time of total realization--not only of the risk implied by the explosion of subprime mortgages, but also of the connection between equities and interest rate markets. By reviewing eurodollar yield spreads, we can see the evolution of risk from its beginning to potential conclusion.
Eurodollar futures provide a means to hedge interest rates as well as a way to speculate on changes in interest rates. A third capability--confirming or fore-casting credit risk--is an aspect of eurodollar futures that can prove to be a valuable tool for traders and investors in equities. January through December 2007 is a period in which the spreads between Eurodollar yields, Treasury yields and T-note futures yields showed the direction and depth of credit risk in financial markets.
"Yield spreads" (right) charts eurodollar futures yields with 10-year maturity (see "Calculating the 10-year Eurodollar yield," right) subtracted from 10-year Treasury yields and T-note futures yields. The spreads are allowed to be negative so that their movements match the effect of risk on market prices. The eurodollar credit spread--an indicator of risk for financial markets--is measured by the spread between Eurodollar yields and nominal T-note yields.
According to the chart of Eurodollar yield spreads, the period from September through year-end 2006 is one of stability and moderate risk. Beginning in January 2007, risk (as measured by the spread) gathered strength until it accelerated in the first week of June through Aug. 1. As August began, turmoil in global credit markets forced the Federal Reserve and other central banks to inject large …