The following article is reprinted from the September/October, 2000 issue
of
On the Edge, the Interactive Data Fixed Income Analytics bimonthly newsletter.
Back-to-Basics: Eurodollar Futures
Teri Geske
Senior Vice President, Product Development
In this issue of Back-to-Basics we review the basics of Eurodollar futures contracts, the most widely traded derivative instrument in the world. Even if you have never used Eurodollar futures it is helpful to understand the fundamentals of this market, as the yields on these contracts are used to value other derivatives, including caps and floors and interest rate swaps, and can be used to construct a “LIBOR curve” from which one can compute a LIBOR-based OAS for bonds (see related article on page 6 of the September/October "On the Edge" newsletter). To get a feel for the size of the market we can look at the open interest for Eurodollar futures contracts listed on the Chicago Mercantile Exchange. On a typical day this is about 3.2 million contracts, over three times the open interest for the 30 year and 10 year Treasury futures contracts combined.
One Eurodollar futures contract represents the obligation to pay or receive a quarterly interest payment based on the yield of 3-month LIBOR on a notional amount of $1 million, at the expiration date. Unlike the Treasury futures market, there is no physical settlement with Eurodollar futures; the buyer of the contract receives or owes a cash payment based on the change in 3-month LIBOR from the time the contract was purchased to the expiration date (in fact, the positions are marked-to-market every day, so the payment on the expiration date is merely the final mark-to-market). For every one basis point increase/(decrease) in the annualized LIBOR rate, the buyer receives/(owes) $25, based on this simple arithmetic: $1,000,000 face value x .01%/4 = $25. For example, if the contract is purchased today with a rate of 7.00% and at the expiration date the yield of 3-month LIBOR is 7.05%, the total mark-to-market payments would result in the buyer receiving $25 x 5 = $125 per contract.
Eurodollar futures are traded with quarterly expiration dates of March, June, September and December, extending out for 10 years (up to the mid-1990’s, these contracts only traded out to five years). For convenience, the price of the Eurodollar futures contract is quoted as 100 – R, where R = the annualized futures yield, i.e. the “expected” future yield of 3-month LIBOR. For example, the price of the September 2003 contract as of July 31, 2000, was 92.93, so the futures rate on the contract was 100 – 92.93 = 7.07%. Since they are exchange-traded, Eurodollar futures have no counterparty risk which gives them a certain advantage over other, privately negotiated derivative contracts, particularly for long-dated maturities.
The following example shows how we can use Eurodollar futures to hedge against changes in short-term interest rates. Imagine Company X issues a floating rate note (FRN) that pays a coupon rate of LIBOR + 50bps and wants to hedge against changes in LIBOR. The company enters into a series of Eurodollar futures contracts with expiration dates that match the coupon reset dates of the FRN. As LIBOR increases, the payout on the FRN also increases, but the increase is offset by the payoff from the futures contracts so Company X’s net borrowing cost is unaffected by changes in LIBOR.
The rate on a Eurodollar futures contract expiring N years into the future represents the market consensus for the value of 3-month LIBOR as of that future date. For example, comparing the September 2003 Eurodollar futures rate of 7.07% to the current 3-month LIBOR rate of 6.72% suggests expectations of higher short-term interest rates three years from now. It is possible to construct an entire yield curve of expected forward short-term LIBOR rates using Eurodollar futures contracts of various maturities. This "futures" yield curve (similar but not identical to a "forward" curve), representing consensus expectations for the future of LIBOR, can be used to price instruments whose value depends upon the path of short-term rates, such as an interest rate cap or floor that pays the buyer if and only if a floating interest rate exceeds or falls below a certain maximum or minimum “strike” rate, or an interest rate swap, where one party pays a fixed interest rate in exchange for a series of floating rate payments.
It is easy to see that the Eurodollar futures market and swap market must be closely linked. The floating rate payments on a LIBOR-based swap can be closely replicated by a series of eurodollar futures contracts whose expiration dates match the payment dates on the swap, and those wishing to hedge floating rate exposure can choose which of the two approaches best meets their needs1 (in the example above, Company X could have received LIBOR and paid the fixed rate on a swap to achieve the same result). The Eurodollar futures market is also affected by the demand to hedge fixed rate exposure through the swaps market, as follows: We know that swaps can be used to hedge fixed rate corporate bond positions (there is a strong correlation between changes in swap rates and changes in bond yields). We also know that the fixed rate on a swap of N years is a function of the expected future LIBOR payments on the floating leg of the swap out to that future date. Since the floating rate payer on a swap will often use Eurodollar futures (which reflect expected future LIBOR rates) to hedge that exposure, the use of swaps to hedge fixed rate positions is also tied into the Eurodollar futures market2.
BondEdge offers complete coverage of all Eurodollar futures with daily closing prices from the CME. Contract symbols are a four-digit identifier: EDXY where X is the expiration month (H,M,U or Z for March, June, September and December expirations), and Y is the last digit of the expiration year – e.g., EDM5 is the symbol for the March 2005 contract. The Security Calculator screen shows the price, yield and open interest on each contract, and a comparison of the near-term Eurodollar futures rates versus implied forward rates derived from the cash LIBOR market.
We hope this review of the Eurodollar futures market has been useful. As always, we welcome your questions, comments and suggestions for future Back-to-Basics articles.
1 There are many detailed descriptions of how to make this comparison – see, for example, “Comparing Eurodollar Strips to Interest Rate Swaps,” Ira G. Kawaller, Journal of Derivatives, Fall 1994.
2 Although the Eurodollar futures and interest rate swaps markets are closely related, there are some important differences between the two that make them imperfect substitutes.
