In: Finance
1. It is April 2019. A US company needs to borrow $100,000,000 for three months starting five months from now. The current 3-month LIBOR is 2.5%. The company is afraid that rates may rise during those five months before it obtains the loan. Should the company buy or sell Eurodollar futures? And how many (ignoring the present value of the basis point change)?
Which month should the futures settle/expire?
Assume that the appropriate Eurodollar future is trading at 97.4. What interest does the company pay if the 3-month LIBOR rate finishes at 95 (factoring in the gain/loss of the Eurodollar futures contracts)? Or finishes at 98? Assume each month has 30 days.
This is a very interesting question and needs a thorough understanding of the Eurodollar futures to answer. I will try to break down the concepts and explain the answer by logical steps.
The company needs to borrow the money in future. The adverse impact for borrowing would be the interest rates going up. Hence, we need a hedging instrument that will protect against rising interest rate risk. The instrument used here is the Eurodollar futures (EDF). The underlying for EDF is a Eurodollar time deposit which at the rate of 3-months LIBOR.
We will need to short-sell the EDF to protect against the rising interest rates. The price of EDF reflects the anticipated LIBOR rates at the time of settlement. By short selling the contract, the company profits from the rising interest rates, which is captured in the lower EDF prices.
The money needs to be borrowed in 5 months i.e. at the end of Sept’19. Hence, the contract needs to be settled in Sept. The maturity of EDF contracts is usually 3 months. The period for which the money needs to be borrowed is not important here. The expiration months for EDF on CME exchange are March, June, September and December.
The principal or notional value for EDF is $1M. Since we need to borrow $1 M only, we can purchase a single Eurodollar future contract.
The tick size or minimum fluctuation for EDF is 0.0025 bps or 0.25% in the nearest expiring month and 0.005 bps or 0.5% for all other months. Since, the contract is for 5 months, this is not the nearest expiry month contract and the relevant tick size as of today will be 0.5%. One basis point change in the EDF price reflects a change of $25 per contract.
EDF prices are expressed numerically as- 100 minus the implied 3-month LIBOR rate. The EDF price of 97.4 reflects an implied LIBOR of 2.6%. If the EDF at expiry is 95 which implies that the LIBOR is 5% at the time of borrowing the money. The gain from short selling the EDF at 97.5 and covering the sell at 95 at the time of expiry is 97.4-95= 2.4% or 240 bps. Hence, a move of 240 bps will reflect a change of $6000 per contract, which is a gain in this case. The effective interest rate is calculated as below-
Principal borrowed | 1,000,000 |
LIBOR | 5% |
Interest rate | 12,500 |
Gains from EDF | 6000 |
Net interest payout | 6,500 |
Effective interest rate | 2.60% |
In second case, when the EDF price at expiry is 98, the implied LIBOR is 2%. The loss from short selling the EDF at 97.5 and covering the sell at 98 at the time of expiry is 97.4-98= -0.6% or 60 bps. Hence, a move of 60 bps will reflect a change of $1500 per contract, which is a gain in this case. The effective interest rate is calculated as below-
Principal borrowed | 1,000,000 |
LIBOR | 2% |
Interest rate | 5,000 |
Loss from EDF | -1500 |
Net interest payout | 6,500 |
Effective interest rate | 2.60% |
Notice how in each case, the effective rate of borrowing is fixed at 2.6% which is the implied LIBOR from the EDF price at the time of purchasing the hedge.