QUOTE AND NEWS
Mondo Visione  Aug 7  Comment 
The U.S. Commodity Futures Trading Commission (CFTC) today issued an Order filing and settling charges against The Bank of Tokyo-Mitsubishi UFJ, Ltd. (BTMU) for engaging in multiple acts of spoofing in a variety of futures contracts on the...
Commodity Online  Sep 19  Comment 
Eurodollar futures and options combined reached 8,463,031 contracts, its third highest day overall. In addition, CME Group also cleared $300 billion in Interest Rate Swaps, the second highest day of all time.
Mondo Visione  Sep 18  Comment 
CME Group, the world's leading and most diverse derivatives marketplace, announced a Eurodollar futures record volume day with 6,880,382 contracts traded on Sept. 17, 2014, exceeding the previous record of 6,039,753 contracts, which occurred on...
SeekingAlpha  May 14  Comment 
By Marc Chandler: This Great Graphic, created on Bloomberg, depicts the dollar against sterling, rather than sterling against the dollar, as normally quoted (yellow line) and the March 15 short-sterling futures contract (white line)....
Clusterstock  Jan 15  Comment 
Short-term interest rates are rising fast today after a similar jump yesterday as traders fade the initial market reaction to Friday's release of worse-than-expected December jobs numbers. The chart of the day shows expected future yields on...
Bloomberg  Jun 24  Comment 
Why Wall Street Doesn't Trust the Fed Evan Soltas
Mondo Visione  Feb 22  Comment 
5-Year "Purple" Mid-curve options on Eurodollar futures: Attached is an advisory notice detailing contract specifications for the new 5-Year "Purple" Mid-curve on Eurodollar futures...




 
TOP CONTRIBUTORS


Eurodollar futures are a way for companies and banks to lock in an interest rate today, for money it intends to borrow or lend in the future. They are traded on the Chicago Mercantile Exchange (CME), and are the most widely traded futures in the world, with open interest (number of contracts outstanding) typically in the 7 to 9 million range for the shortest maturity futures.[1]

Eurodollar futures are a cash settled futures contract on an interest rate for a 3 month loan with a $1 million notional value. They are essentially the futures equivalent of forward rate agreements (FRAs). However, because Eurodollar futures are exchange traded, they offer greater liquidity and lower transaction costs, but can not be customized like over the counter (OTC) FRAs. Since Eurodollar futures are margined, there is virtually no credit risk because any gains or losses are marked to market, or in other words they are paid daily. As such, if interest rates move in your favor, you receive cash compensation that day rather than waiting until expiry; these settlements are done every day. Since the contract is cash settled, no loan is actually extended even though the contract mentions a notional principal amount.

Many banks and large corporations will use Eurodollar futures to hedge future interest rate exposure. Sellers hedge against the risk of rising interest rates, while buyers hedge against the risk of falling interest rates. Other parties that use Eurodollar futures are speculators purely looking to make bets on future directional changes in interest rates.

Eurodollar futures terminology

Pricing of Eurodollar futures is unique in the sense that it is quoted as numerical price, despite the fact that it is an interest rate. The price quoted is simply 100 minus the implied interest rate. For instance, a price of 95.00 means an interest rate of 5.0%, while a price of 93.00 implies an interest rate of 7.0%.

  • Margining refers to a method of settling gains and losses daily. The basic idea is that both the seller and the buyer of the contract puts up an initial margin account, and gains are added to this account (losses are subtracted). If the margin account falls below a certain level (called the maintenance margin), then the CME will make a margin call, forcing the investor to either replenish money in the margin account or to close their position. Because margining is done many times throughout each trading day, this effectively eliminates credit risk from the futures contract.
  • Ticks are a 0.01 change in the price (.01% change in the interest rate) of the futures contract, or the change of a single basis point (bps). In dollar terms, each tick represents a $25 gain or loss that must be paid out of a margin account. The $25 is derived as follows: $1,000,000 notional loan *(.01%)*(90/360)=$25.00. For instance, if the price were to drop from 95.00 to 94.99, then $25 is paid from the buyer's margin account into the margin account of the seller.

Mechanics of Eurodollar Futures

Consider Company Z on March 1, 2009, which due to unforeseen circumstances must now find $10 million for an expenditure that will occur on June 1, 2009. Company Z expects to generate revenue over time, and the company expects to be able to repay this amount on September 1, 2009. Company Z has a number of ways to meet this expenditure; in this example we only compare a traditional loan to Eurodollar futures.

Let's assume Company Z can normally borrow funds for 3 months from its local bank at a rate of 3 month Libor plus 100 basis points (bps). If the company takes the first alternative, the effective interest rate it would be able to borrow at would remain unknown until June 1, when it borrows the actual $10 million at 3 month Libor plus 100 bps. Note that this represents a variable interest rate, as the interest rate in 3 months remain unknown until the actual day arrives. What if the company wishes to know on March 1, 2009 the interest they must pay on the loan, which will not occur for another 3 months?

Company Z can also sell 10 Eurodollar future contracts (for total notional principal of $10 million) that expire on June 1, 2009. Let's assume that on March 1, 2009 the price of Eurodollar futures is exactly 93.00, implying an interest rate of 7.0%, and that at expiry (June 1, 2009) the final closing price is 92.50, implying an interest rate of 7.5%. Since the futures price decreased 50 basis points, Company Z would have received a total of $12,500 ($25 x 50 ticks x 10 contracts) from buyers of the contract. At expiry, all accounts are margined to the final closing price and closed; there is no more activity related to this specific Eurodollar futures contract.

How do Eurodollar futures lock in interest rates?

Continuing the example from above, Company Z has an expense of $10 million on June 1, 2009. However, it has received $12,500 from the Eurodollar futures contracts, and as a result now only needs to borrow $9,987,500, or $10 million less the amount it received from the contract. It now goes to its local bank (from earlier in the example) and borrows this amount at its established rate of 100 basis points above the 3 month Libor. The 3 month Libor is now observable as 7.5%, which is the same figure that the Eurodollar futures uses to close trading.

Company Z now borrows $9,987,500 at an interest rate of 8.5%. Company Z's overall cost of financing is { $9,987,500 * (1+ 0.085 * [ 90 / 360 ] ) / $10,000,000 } -1, which comes out to 2.0%. When annualized, Company Z's actual cost of borrowing $10 million is 8.0%, which is exactly the Eurodollar futures price of 7.0% it agreed upon plus the 100 basis points cost of borrowing from its local bank.

References

  1. CME Group. Volume Data.
Wikinvest © 2006, 2007, 2008, 2009, 2010, 2011, 2012. Use of this site is subject to express Terms of Service, Privacy Policy, and Disclaimer. By continuing past this page, you agree to abide by these terms. Any information provided by Wikinvest, including but not limited to company data, competitors, business analysis, market share, sales revenues and other operating metrics, earnings call analysis, conference call transcripts, industry information, or price targets should not be construed as research, trading tips or recommendations, or investment advice and is provided with no warrants as to its accuracy. Stock market data, including US and International equity symbols, stock quotes, share prices, earnings ratios, and other fundamental data is provided by data partners. Stock market quotes delayed at least 15 minutes for NASDAQ, 20 mins for NYSE and AMEX. Market data by Xignite. See data providers for more details. Company names, products, services and branding cited herein may be trademarks or registered trademarks of their respective owners. The use of trademarks or service marks of another is not a representation that the other is affiliated with, sponsors, is sponsored by, endorses, or is endorsed by Wikinvest.
Powered by MediaWiki