Question

Explain in your own words the reason why a Eurodollar futures contract needs to be tailed in order to hedge the rate paid on a loan that is taken out at a future date. State the term (or name) for the difference between the FRA (forward rate agreement) rate and Eurodollar rate. If there were no difference between the Eurodollar rate and the FRA rate, state who is systematically favoured in a Eurodollar futures contract: the borrower or the lender.

Answer 1

The Eurodollar futures contract refers to the financial futures contract based upon these deposits, traded at the Chicago Mercantile Exchange (CME). A Eurodollar future is a cash settled futures contract whose price moves in response to the interest rate offered on US Dollar denominated deposits held in European banks.

Futures contracts

The Eurodollar futures contract refers to the financial futures contract based upon these deposits, traded at the Chicago Mercantile Exchange (CME). More specifically, EuroDollar futures contracts are derivatives on the interest rate paid on those deposits. A Eurodollar future is a cash settled futures contract whose price moves in response to the LIBOR interest rate  . Eurodollar futures are a way for companies and banks to lock in an interest rate today, for money they intend to borrow or lend in the future. Each CME Eurodollar futures contract has a notional or "face value" of $1,000,000, though the leverage used in futures allows one contract to be traded with a margin of about one thousand dollars.

CME Eurodollar futures prices are determined by the market's forecast of the 3-month USD LIBOR interest rate expected to prevail on the settlement date. A price of 95.00 implies an interest rate of 100.00 - 95.00, or 5%. The settlement price of a contract is defined to be 100.00 minus the official British Bankers' Association fixing of 3-month LIBOR on the day the contract is settled.

How the Eurodollar futures contract works

For example, if on a particular day an investor buys a single three-month contract at 95.00 (implied settlement LIBOR of 5.00%):

• if at the close of business on that day, the contract price has risen to 95.01 (implying a LIBOR decrease to 4.99%), US$25 will be paid into the investor's margin account; or
• if at the close of business on that day, the contract price has fallen to 94.99 (implying a LIBOR increase to 5.01%), US$25 will be deducted from the investor's margin account.

On the settlement date, the settlement price is determined by the actual LIBOR fixing for that day rather than a market-determined contract price.

difference between forward rate agreements (FRA) and Eurodollar rate

If you need to borrow some money in future and you assume that by that time interest may go up, then you will try to protect the interest rate by entering into a FRA agreement with some party who has opposite assumption on the movement of the interest rate.

If interest goes up then you profit or if interest goes down you will loose. Suppose today interest rate is 3%, so you will enter into a contract with some lender, that after say 6 months or 1 year etc., you will borrow money at 3% rate. So on the execution day if interest rate is more than 3% then you made profit, or if it less than 3%, then you loose.

While Interest rates futures are derivatives with underlying interest bearing instruments like bond futures. If you are shorting a bond future and in future the interest goes down then the underlying bond price will reduce. At that moment you will buy fresh bonds at reduced price to close your short position and book the profit.

Forward Rate Agreements, or FRAs, are a way for a company to lock in an interest rate today, for money the company intends to lend or borrow in the future.

FRAs are cash-settled forward contract on interest rates. This means that no loan is actually extended, even though a notional principal amount mentioned in the contract. Instead, the borrower and the lender agree to pay each other the interest difference between the agreed-upon rate and the actual interest rate on the future date. The cash settlement occurs on the day the loan is set to begin.

Many banks and large corporations will use FRAs to hedge future interest rate exposure. The buyer hedges against the risk of rising interest rates, while the seller hedges against the risk of falling interest rates. Other parties that use Forward Rate Agreements are speculators purely looking to make bets on future directional changes in interest rates.

Eurodollar Futures

The Chicago Mercantile Exchange (CME) launched the eurodollar futures contract in 1981, marking the first cash-settled futures contract. The underlying instrument in eurodollar futures is a eurodollar time deposit, having a principal value of $1 million with a three-month maturity. On expiration, the seller of cash-settled futures contracts can transfer the associated cash position rather than making a delivery of the underlying asset. (However, most traders close futures contracts prior to the expiration through an offsetting transaction to avoid delivery.)

Eurodollar futures were initially traded on the upper floor of the Chicago Mercantile Exchange in its largest pit, which accommodated as many as 1,500 traders and clerks. The majority of eurodollar futures trading now takes place electronically.

Trading eurodollar futures contracts requires an account with a brokerage firm that offers futures trading along with an initial deposit, called margin.

The open outcry eurodollar contract symbol (i.e. used on trading floors, where orders are communicated by shouts and hand signals) is ED and the electronic contract symbol is GE. Electronic trading of eurodollar futures takes place on the CME Globex electronic trading platform, Sunday through Friday, 6 p.m. to 5 p.m. EST. The expiration months are March, June, September and December, as with other financial futures contracts. Tick size (minimum fluctuation) is one-quarter of one basis point (0.0025 = $6.25 per contract) in the nearest expiring contract month and one-half of one basis point (0.005 = $12.50 per contract) in all other contract months.

Eurodollars have grown to be one of the leading contracts offered on the CME in terms of average daily volume and open interest (the total number of open contracts). The futures often surpass the E-Mini S&P 500 futures (an electronically traded futures contract one-fifth the size of the standard S&P 500 futures contract), crude oil futures, and 10-Year Treasury Note futures in terms of average daily trading volume and open interest.

LIBOR and Eurodollars

The price of eurodollar futures reflects the interest rate offered on U.S. dollar-denominated deposits held in banks outside the United States. More specifically, the price reflects the market gauge of the 3-month U.S. dollar LIBOR (London Interbank Offered Rate) interest rate anticipated on the settlement date of the contract. LIBOR is a benchmark for short-term interest rates at which banks can borrow funds in the London interbank market. Eurodollar futures are a LIBOR-based derivative, reflecting the London Interbank Offered Rate for a 3-month $1 million offshore deposit.

Eurodollar futures prices are expressed numerically using 100 minus the implied 3-month U.S. dollar LIBOR interest rate. In this way, a eurodollar futures price of $96.00 reflects an implied settlement interest rate of 4%, or 100 minus 96. Price moves inverse to yield.

For example, if an investor buys one eurodollar futures contract at $96.00 and the price rises to $96.02, this corresponds to a lower implied settlement of LIBOR at 3.98%. The buyer of the futures contract will have made $50. (1 basis point, 0.01, is equal to $25 per contract, then a move of 0.02 equals a change of $50 per contract.)

Hedging with Eurodollar Futures

Eurodollar futures provide an effective means for companies and banks to secure an interest rate for money it plans to borrow or lend in the future. The eurodollar contract is used to hedge against yield curve changes over multiple years into the future.

For example, say a company knows in September that it will need to borrow $8 million in December to make a purchase. Recall that each eurodollar futures contract represents a $1 million time deposit with a three-month maturity. The company can hedge against an adverse move in interest rates during that three-month period by short selling eight December eurodollar futures contracts, representing the $8 million needed for the purchase.

The price of eurodollar futures reflects the anticipated London Interbank Offered Rate (LIBOR) at the time of settlement or, in this case, December. By short selling the December contract, the company profits from upward movement in interest rates, reflected in correspondingly lower December eurodollar futures prices.

Let’s assume that on Sept. 1, the December eurodollar futures contract price was exactly $96.00, implying an interest rate of 4.0%, and at the expiry in December, the final closing price is $95.00, reflecting a higher interest rate of 5.0%. If the company had sold eight December eurodollar contracts at $96.00 in September, it would have profited by 100 basis points (100 x $25 = $2,500) on eight contracts, equaling $20,000 ($2,500 x 8) when it covered the short position.

In this way, the company was able to offset the rise in interest rates, effectively locking in the anticipated LIBOR for December as it was reflected in the price of the December eurodollar contract at the time it made the short sale in September.

Speculating With Eurodollar Futures

As an interest rate product, the policy decisions of the U.S. Federal Reserve have a major impact on the price of eurodollar futures. As a result, volatility in the eurodollar market is often 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, and eurodollar futures are impacted by these major trends in monetary policy.

The long-term trending qualities of eurodollar futures make the contract an appealing choice for traders using trend-following strategies. Consider the following chart between 2000 and 2007, where the eurodollar trended upward for 15 consecutive months and later trended lower for 27 consecutive months.