Pascal Spreading of Short-Term Interest Rate Contracts
June 2000
John Merrick
ABSTRACT
This paper examines the spreading and pricing of short-term interest rate futures contracts and shows how traditional
types of calendar spread positions can emerge as explicit arbitrage solutions. A specific set of intuitive spreading
structures – “Pascal’s Spreading Triangle” – arises when the underlying daily risk factors are identified as the
stochastic coefficients of a high-ordered polynomial approximation to the yield curve. No empirically estimated
hedge ratios are required for these arbitrage strategies. Application of this Pascal Spreads framework to pricing
and trading the LIFFE’s Short Sterling deposit futures market over the 1989 to 1998 sample period reveals that
the LIFFE’s Short Sterling arbitrage sector’s efficiency has improved markedly over time. The improvement over
the decade coincides with the dramatic declines in futures trading transactions costs. As a byproduct, the framework
extracts and measures the quantitative impact of the Y2K millennium-turn pricing distortion on the December 1999
Short Sterling futures contract.
John Merrick
Institution: Stern School of Business, New York University
Email: jmerrick@stern.nyu.edu
Telephone: (212) 998-0378
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