Eurodollar futures are the most widely traded futures in the world. They were launched in 1982 by the Chicago Mercantile Exchange (CME). Today, contracts trade there as well on the Singapore Futures Exchange (SGX) and Euronext. Most of the volume is in Chicago, followed by Singapore and then Europe. The Chicago and Singapore contracts are identical, and there is a mutual offset program between the two exchanges that makes their contracts fungible. The Chicago and Singapore contracts are cash settled. So is the European contract, but for historical regulatory reasons, it also offers a physical settlement option, which the others do not. This is rarely used. Despite its minor differences, and the fact that it cannot be offset against the Chicago or Singapore contracts, prices of the European contracts closely track those of the other two. A Eurodollar future is a future on a three-month Eurodollar deposit of one million US dollars. Final settlement at expiration is based on the value of 3-month BBA Libor. Eurodollar futures are the exchange-traded equivalent of over-the-counter forward rate agreements (FRAs). FRAs have the advantage of being customizable. Eurodollar futures offer greater liquidity and lower transaction costs. Also, like all futures, Eurodollar futures eliminate credit risk through a margining process. FRAs do not. If Eurodollar futures were being introduced today, they would probably be quoted with forward interest rates on the underlying deposits. Back in 1982, though, cash settled financial futures were a novelty. Trading was performed face-to-face in "trading pits" by traders who were more familiar with trading cattle or pork bellies. They thought in terms of prices instead of interest rates, so the exchange specified a formula for the "price" of a Eurodollar future in terms of its interest rate. This is the same formula the exchange had introduced for its t-bill future. If a trader wants to quote a Eurodollar future for some interest rate r, she converts r to a price for quoting purposes with
For example, if a Eurodollar future is quoted at 94.25, this corresponds to an interest rate of 5.75%. Each .01 unit of price corresponds to a basis point, but it is called a tick. Prices are quoted to within a half tick (.005) for all contracts except the one closest to expiration, which is quoted to within a quarter tick. Daily margining is set equal to $25 per tick. For example, if a contract's settlement price changes from 94.25 to 94.22 from one day to the next, traders who are long must pay 3 x ($25) = $75 per contract in margin. There are contracts that expire every March, June, September and December out to ten years. Additionally, there are contracts expiring in the upcoming four months not covered by the quarterly expirations. In total, 44 contracts trade at any given time. Exhibit 1 shows available contracts and their settlement prices for June 25, 2007.
Although the contracts are cash settled, the underlying deposits are thought of as spot deposits commencing on the third Wednesday of a contract's expiration month. Since a spot deposit has two days' settlement, trading ceases two London business days before that date.
Eurodollar futures are widely used for hedging fixed income obligations and especially fixed income derivatives. A simple example can be informative. Suppose today is June 25, 2007, so the contracts of Exhibit 1 are available. A trader is to make a cash payment of $3 million on December 15, 2008, and she wants to hedge the interest rate risk. She goes long three each of the Sep 2007, Dec 2007, Mar 2008, Jun 2008 and Sep 2008 contracts. If you think of each future as a 3-month forward loan, she has strung together a series of five 3-month forward loans to make a 15-month forward loan, commencing in September 2007 and maturing in December 2008. That forward loan would, if futures were physically settled, have her pay a sum equal to the present value of $3 million in September 2007 and return $3 million to her in December 2008, offsetting her $3 million cash outflow scheduled for that month. The hedge has the effect of replacing an eighteen-month duration portfolio with a three-month duration portfolio, substantially reducing the interest rate risk. The Eurodollar futures hedge and its interpretation as a forward loan are illustrated in Exhibit 2.
In the example, we see that it took fifteen futures contracts, of five different expirations, to hedge a single cash flow. Such laddered positions arise frequently in hedging with Eurodollar futures, and they have a name. A Eurodollar futures strip, or simply a Eurodollar strip, is a position consisting of an equal number of each of several consecutive quarterly Eurodollar futures.
To facilitate hedging, the CME allows trading in entire strips, which the exchange calls bundles. A bundle is a strip of consecutive quarterly contracts—one future for each expiration. Bundles generally start with the front quarterly contract, so a one-year bundle consists of the first four quarterly contracts; a two-year bundle consists of the first eight quarterly contracts, etc. There is also a forward bundle, which comprises 20 contracts, covering years five through ten. Another form of strip that can be directly traded on the CME is packs. These are strips of one each of four consecutive quarterly contracts. There is a pack for the first four quarterly contracts, the second four quarterly contracts, and so on. There are several shortcomings of the hedge in our example. One is that it hedges interest rate risk but leaves liquidity risk unaddressed. This is typical of any hedge using cash-settled futures. More importantly, the hedge only partially addresses the interest rate risk. Consider three issues:
As a practical matter, Eurodollar hedges are far from perfect. If our trader wanted a more perfect hedge, she would go out and negotiate an actual deposit commencing immediately and maturing on December 15. Arranging such a customized deal would take time, and she would have to pay a bid-ask spread. As exchange-traded instruments, Eurodollar futures offer only standardized expirations and a fixed $1 million notional amount. A trader has to construct the best hedge she can with what is available. What she gains with Eurodollar futures is savings in time and money. The Eurodollar futures market is extremely liquid, so she can hedge even large exposures quickly and for almost no cost. If she wanted to, a trader could tweak the hedge in our example to better address the interest rate risk. The example was useful for illustrating how Eurodollar strips arise naturally when hedging with Eurodollar futures. As a practical matter, traders don't think of their Eurodollar futures hedges as forming hypothetical forward loans. They construct hedges using sensitivity analysis as follows:
During the early 1990s, awareness spread that the margining process for Eurodollar futures introduced a slight bias in how they are priced. Called convexity bias, this should cause Eurodollar futures rates to slightly exceed corresponding forward rates, especially at longer maturities. Until the 1990s, traders would construct a forward curve directly from Eurodollar rates and use this for pricing other instruments, such as swaps and FRAs. Recognizing that there is a convexity bias in Eurodollar rates, traders no longer do that. Instead, they construct a spot curve from Libor rates and swap rates. Called the Libor-swap curve, this has emerged as the benchmark for pricing many dollar-denominated fixed income obligations. Modeled after Eurodollar futures, there are other cash-settled futures traded on exchanges around the world for 3-month deposits in different currencies. These include Eurosterling futures, Euroyen futures, Euroswiss futures and Euroeuro futures. The term Eurocurrency futures collectively refers to all these contracts, including Eurodollar futures.
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The
hedge has the effect of replacing an eighteen-month duration portfolio
with a three-month duration portfolio, but a better hedge would replace
it with a cash (zero duration) portfolio. There simply isn't a
short-dated Eurodollar future that she can add to her hedge to
accomplish this.
