Question

Briefly discuss the profit/loss from the Eurodollar futures position relative to the interest calculation on the FRA at the beginning and the immediate deposit/borrow at the end. Why are they different or the same? Answer this question in a few short sentences.

Answer 1

As an interest rate product, the policy decisions of the U.S. Federal Reserve have a major impact on the price of eurodollar futures. Volatility in this market is normally seen around important Federal Open Market Committee (FOMC) announcements and economic releases that could influence Federal Reserve monetary policy.

A change in Federal Reserve policy toward lowering or raising interest rates can take place over a period of years. Eurodollar futures are impacted by these major trends in monetary policy.

The high levels of liquidity along with relatively low levels of intraday volatility (i.e. within one day) create an opportunity for traders using a “market making” style of trading. Traders using this non-directional strategy (neither bullish nor bearish) place orders on the bid and the offer simultaneously, attempting to capture the spread. More sophisticated strategies such as arbitrage and spreading against other contracts are also used by traders in the eurodollar futures market.

Eurodollars are used in the TED spread, which is used as an indicator of credit risk. The TED spread is the price difference between interest rates on three-month futures contracts for U.S. Treasuries and three-month contracts for eurodollars with the same expiration months. TED is an acronym using T-Bill and ED, the symbol for the eurodollar futures contract. An increase or decrease in the TED spread reflects sentiment on the default risk level of interbank loans.

Eurodollars are often overlooked by retail traders who tend to gravitate toward futures contracts that offer more short-term volatility, such as the E-mini S&P or crude oil. However, the deep level of liquidity and long-term trending qualities of the eurodollar market present interesting opportunities for small and large futures traders alike.

FRAs are customized contracts that can be obtained through investment banks. These banks hedge the risk of these products by using Eurodollar futures. In hedging the sale of a forward contract with futures, the marking to market feature of futures must be considered. As a result, the pricing of FRAs is very competitive and bid-ask spreads are very narrow as arbitrage opportunities keep prices in the two markets very closely aligned.

Notice that a firm that buys a FRA gains from interest rate increases. In contrast, a long position in a ED futures contract gains if interest rates decline. Buying a FRA is almost identical to selling a ED futures contract. Of course, since FRAs are forward contracts they are not marked to market daily as ED futures. Banks can use ED futures to hedge exposed FRAs. Unlike exchange traded futures, however, the FRA can be customized to closely conform to the specific risk being hedged by the firm.

You can think of an FRA as the OTC equivalent of a Eurodollar futures contract. Banks use FRAs to fix interest costs on anticipated future deposits or interest revenues on variable-rate loans. A bank that sells an FRA agrees to pay the buyer the increased interest cost on some notional principal amount if interest rates rise above the agreed (“forward”) rate on the contrat maturity or settlement rate. On the other hand, the buyer agrees to pay the seller the increased interest cost if interest rates fall below the forward rate.

Contrary to an FRA, Eurocurrency future's cash flow is based on exactly ninety days and is not discounted to the beginning of the period. Thus, the interest rate on Eurocurrency futures cannot be identified with the implied forward rate used to calculate break-even loan costs. The FRA rate, by contrast, is the same as the implied forward rate.

There are therefore two differences between a Eurodollar futures contract and an FRA. These are: 1. The difference between a Eurodollar futures contract and a similar contract where there is no daily settlement. The latter is a forward contract where a payoff equal to the difference between the forward interest rate and the realized interest rate is paid at time T1.

The difference between a forward contract where there is settlement at time T1 and a forward contract where there is settlement at time h These two components to the difference between the contracts cause some confusion in practice. Both decrease the forward rate relative to the futures rate; but for long-dated contracts the reduction caused by the second difference is much smaller than that caused by the first.