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Pricing Eurodollar Futures Options with an American Exercise Model

Article Quant Q&A · Author: Little
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Summary

The document discusses how market participants price American options on Eurodollar futures and when a European-option approximation may be adequate. It contrasts tree-based models that represent early exercise with the simpler European treatment often used by dealers managing these options as part of broader over-the-counter hedging portfolios.

The explanation focuses on the value of receiving the underlying futures position and variation margin immediately upon exercise, rather than waiting for a discounted payoff at expiration. A deep in-the-money, long-dated call illustrates how early exercise can matter when interest rates are high enough for discounting to affect value. The response says the approximation error is generally limited and concentrates in those cases. A follow-up adds that volatility can influence the decision: as volatility approaches zero, earlier exercise may become more attractive when rates are positive. These are practitioner observations, not a general numerical error bound or a full pricing derivation; the discussion is specific to this product and its exercise and margin mechanics.

Key ideas

  • Specialist traders may use tree models that account for early exercise of Eurodollar futures options.
  • Dealers with broader portfolios may approximate the options as European to simplify implementation.
  • Early exercise delivers the futures position and immediate variation margin, avoiding discounting of the payoff until expiration.
  • The European approximation is most consequential for long-dated, deeply in-the-money options when interest rates are high.
  • Lower volatility may make earlier exercise more attractive when rates are positive.

Tags

FuturesOptionsFixed incomeDerivatives pricingVolatility
Full text
# What is the industry standard pricing model for CME-traded Eurodollar future (American) options?


# What is the industry standard pricing model for CME-traded Eurodollar future (American) options?












The CME-traded Eurodollar futures option is an American option.

What is the industry standard pricing model for this product?

Does the industry practice to treat CME-traded Eurodollar futures option as European and use Black-Scholes model to price it (due to daily margin)?

## Answer by dm63 (score 9)

https://quant.stackexchange.com/a/44213

Having traded these options for a number of years I have some insight. It’s my belief that those that make a living specifically out of these options do have tree-style models that take into account early exercise. On the other hand , those that have occasional use of these options (such as interest rate derivatives dealers who might use them to hedge otc derivatives) mostly assume that the options are European, because implementing the full American model is cumbersome within a multi- product portfolio.

It is possible to show that the error committed in assuming the option is European is not very large. Consider the case of a call option on the Mar2020 contract (approx 1year to expiration) , struck at 9450, with the contract trading at 9750. This contract is deep in the money (actually, 300bp In the money). Left unexercised, it is worth 300bp, discounted for one year. However , upon exercise , you get delivered the underlying futures contract, together with 300bp of immediate variation margin. This situation is worth 300bp , not discounted. Hence , it is my experience that the modeling error only shows up for long dated, deep in the money options , and then only when interest rates are high enough to make a discounting difference.

I hope that helps.

## Answer by Arshdeep (score 2)

https://quant.stackexchange.com/a/55789

To add to @DM63's answer, as a secondary characterisitc, vol may also matter in deciding the european approximation impact. As vol goes to 0, you want to exercise as soon as possible, because the underlying future rate becomes a constant (a martingale with no vol). As you'll receive the same payoff at at date, better to get it earlier (if rates are.positive).

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.