Bank & Treasury Management - BSF222
Agustin Mackinlay

a.mackinlay@euruni.edu

Session 5 - February 28, 2012
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From chapter 6 of John C. Hull. Options, Futures, and Other Derivatives, sixth edition, 2005.

EURODOLLAR FUTURES
The most popular interest rate futures contract in the United States is 3-month Eurodollar futures contract traded on the Chicago Mercantile Exchange (CME). A Eurodollar is a dollar deposited in a US or foreign bank outside the United States. The Eurodollar interest rate is the rate of interest earned on Eurodollars deposited by one bank with another bank. It is essentially the same as the London Interbank Offer Rate (LIBOR).

Three-month Eurodollar futures contracts are futures contracts on the 3-month (90-day) Eurodollar interest rate. They allow an investor to lock in an interest rate on $1 million for a future 3-month period. The 3-month period to which the interest rate applies starts on the third Wednesday of the expiration month. The contracts have expiration months of March, June, September and December for up to ten years into the future. This means that in 2004 an investor can use Eurodollar futures to lock in an interest rate fpr 3-month periods that are as far into the future as 2014. 

To understand how Eurodollar futures contracts work, consider the March 2005 contract. This has a settlement price of 97.63. The contract ends on the third Wednesday of the expiration month. The contract is marked to market in the usual way until that date. On March 16, the settlement price is set equal to 100 – I, where i is the actual 3-month Eurodollar interest rate on that day, expressed with quarterly compounding and an actual/360 day count convention. (Thus, if the 3-month Eurodollar interest rate on March 16, 2005, turned out to be 2%, the final settlement price would be 98). There is a final marking to market reflecting the settlement price and all contracts are declared closed. 

The contract is designed so that a 1 basis point (=0.01) move in the futures quote corresponds to a gain or loss of $25 per contract. When a Eurodollar futures quote increases by one basis point, a trader who is long one contract gains $25 and a trader who is short one contract loses $25. Similarly, when the quote decreases by one basis point, a trader who is long one contract loses $25 and a trader who is short one contract gains $25. This is consistent with the point made earlier: that the contract locks in an interest rate on $1 million dollars for 3 months. When an interest rate per year changes by one basis point, the interest earned on 1 million dollar for three months changes by

1,000,000 x 0.0001 x 0.25 = 25

or $25. Because the futures quote is 100 minus the futures interest rate, an investor who is long gains when interest rates fall and an investor who is short gains when interest rates rise.

Example
On February 4, 2004, an investor wants to lock in the interest rate that will be earned on $5 million for 3 months starting on March 16, 2005. The investor goes long five March05 Eurodollar futures contracts at 97.63. On March 16, 2005, the 3-mont LIBOR interest rate is 2%, so that the final settlement price proves to be 98.00. The investor gains 5 x 25 x [(98.00 – 97.63) x 100] = $4,625 on the long futures position. The interest earned on the $5 million for three months is

5,000,000 x 0.25 x 0.02 = 25,000

or $25,000. The gain on the futures contract brings this up to $29,625. This is the interest that would have been earned if the interest rate had been 2.37% (5,000,000 x 0.25 x 0.0237 = 29,625). The illustration shows that the futures trade has the effect of locking in an interest rate equal to 2.37%, or (100 – 97.63)%.
The Chicago Mercantile Exchange defines the contract price as

10,000 [100 – 0.25(100 – Q)]
Where Q is the quote. Thus the settlement price of 97.63 for the March 2005 corresponds to a contract price of 

10,000 [100 – 0.25(100 – 97.63)] = $994,075

In our example the final price is 

10,000 [100 – 0.25(100 – 98.00)] = $995,000

and the difference between the initial and the final contract price is $925, so that an investor with a long position in five contracts gains 5 x 925 dollars, or $4,625 as in the example. This is consistent with the “$25 per 1 basis point move” rule.
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