PowerPoint Presentation
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What are Eurodollars and Eurodollar futures?
US dollars held outside the US banking system
A long Eurodollar future is an agreement to lend US$1,000,000 for three months starting on the contract settlement date.
Buying a contract = lending money, selling a contract = borrowing money
LIBOR: London Inter-Bank Offer Rate: a set of rates across the length of the yield curve from overnight to 12-months
Eurodollars are financially, cash settled
CME Group Eurodollars: based on 3-months LIBOR & are listed for 40 consecutive quarters
A one basis point change in a Eurodollar futures quote corresponds to a contract price change of $25
Example:
An investor buys a single three-month contract at 95.00 (implied settlement LIBOR of 5.00%):
If at the close of business on that day, the contract price has risen to 95.01 (implying a LIBOR decrease to 4.99%), US$25 will be paid into the investor’s margin account
If at the close of business on that day, the contract price has fallen to 94.99 (implying a LIBOR increase to 5.01%), US$25 will be deducted from the investor’s margin account.
On the settlement date, the settlement price is determined by the actual LIBOR on that day
How far into the future does the CME Group offer Eurodollar contracts?
A) 3 months
B) Quarterly for a year
C) Roughly 10 years
D) Monthly for a year
Answer: C
Eurodollar futures are:
A) Cash settled
B) Physically settled
C) Netted and no principal exchanged
D) Always rolled over
Answer: A
Interest Rate Futures/ Money Market
Eurodollars are money market instruments with no periodic payments unlike T-bills or CDs -> trade in yield terms, prices need conversion
Quote price= 100 – Yield
Yield and Quote price have an inverse relationship
What is the Eurodollar contract’s futures price when three-month LIBOR yield = 1.19%?
A) 101.19
B) 98.89
C) 98.81
D) 90.19
Answer: C
In simple words…
Buying a Eurodollar future = agreement to lend money at today’s LIBOR for 3 months -> fixing a rate that you will receive
Selling a Eurodollar future = agreement to borrow money at today’s LIBOR for 3 months -> fixing a rate that you will be paying
Flattening vs steepening yield curve
Steepening curve Flattening curve
The long-term rates stay steady and short-term rates are falling
Or
The long-term rates are growing faster than short-term rates
The short-term rates are growing faster than the long-term
Trading the yield curve changes (calendar spreads)
Steepening Yield Curve strategy Flattening Yield Curve strategy
What is it? Buying a shorter maturity Eurodollar future, selling a longer maturity Eurodollar future
Selling a shorter maturity Eurodollar future, buying a longer maturity
When to use? When long-term IR will stay steady and short-term IR falls
Or
When the market anticipates long-term IR to go up faster than short-term IR
When the market anticipates short-term IR to go up faster than long-term IR
Why? A view that the economy will remain weak, Fed will not change or will lower IR -> short-term are affected A view that the economy will strengthen and Fed is expected to raise short-term rates to head off inflation
When spreading futures contracts, the trader is:
A) Long different expiration months
B) Short different expiration months
C) Simultaneously short and long different expiration months
Answer: C
If the Mar’20 Eurodollar contract is 98.48 and Mar’21 is 98.76. (see slide 4 from lecture) The Mar ‘20-Mar ‘21 calendar spread is?
A) +28 bp
B) – 28 bp
C) +72 bp
Answer: B
If your view was no more Fed easing i.e. interest rates stay the same in 2020 & 2021 how should you trade that spread (in Q5) to make money?
A) Sell the spread by doing a flattening trade
B) Buy the spread by doing a flattening trade
C) Sell the spread by doing a steepening trade
D) Buy the spread by doing a steepening trade
Answer: D
Strip Eurodollar hedge
Eurodollar strips are very successful because they can be used as instruments to hedge interest rate fluctuations
Rising interest rate -> sell Eurodollar futures
Declining interest rates -> buy Eurodollar futures
Example: £100 million 2-year bank loan, 3-months reset LIBOR rate
If rates climb higher over the term of the loan, the short Eurodollar futures contracts would be profitable as the futures decline as rates rise. The profit on the strip of Eurodollar futures would offset the increase borrowing costs effectively locking in a lower rate.
A strip hedge of Eurodollars is:
A) A single Eurodollar futures contract used to hedge a 30-year loan
B) A succession of Eurodollar futures contracts used to hedge individual successive 90 day reset dates on a variable loan
C) Is used primarily for hedging fixed rate loans
Answer: B