Pascal spreading of short-term interest rate contracts

This article 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-order polynomial approximation to the yield curve, No empirically estimated hedge ratios are required for these arbitrage strategies. Application of this Pascal spread framework to pricing and trading the London International Financial Futures Exchange (LIFFE) short sterling deposit futures market over the 1989 to 1998 sample period revealed that the LIFFE's short sterling arbitrage sector's efficiency improved markedly over time. The improvement over the decade coincided with 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. (C) 2000 John Wiley & Sons, Inc.