The Eurodollar Futures Markets
After World War II, several countries started to accumulate US dollars. Such countries opted not to trade US dollars through the U.S. financial system, but to fund them overseas, mostly in banks headquartered in London beyond the jurisdiction of the U.S. government. Gradually, the bank lending market expanded around this fund. The lending rate on this market has started to be referred to as the London Central Bank Offer Rate (LIBOR). This lending market came to be known as the Eurodollars’ future market. The future contracts for Euro Dollars are based on the underlying 3-month LIBOR rates.
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What is the Eurodollar?
Eurodollars are interest rate products. They are the dollars deposited in a U.S. bank or foreign bank outside the United States. Eurodollars are kept outside the U.S. financial system. There can be Eurodollars at every place in the world, and in the United States, if they are kept in a foreign bank branch.
The Eurodollar Futures Contract.
The interest rate of Eurodollar is the amount of interest received on Eurodollars invested by one bank with another bank. A three-month Eurodollar futures contract is a futures contract on the interest that will be paid by anyone who borrows $1 million for a potential three-month duration at the LIBOR interest rate. It allows the trader to speculate on a future interest rate of three months. Eurodollar futures contracts are due in March, June, September, and December for up to 10 years in the future.
How does a Eurodollar Futures Contract work?
The Euro Dollar Deal is cash agreed. When the contract ends, the winners are compensated with the difference in their account between what they have paid for the contract and the actual settlement amount on the losers’ account. The final settlement price of the expired contract is as follows:
100 – LIBOR RATE
Let’s say that the investor wants to lock in the interest rate for a three-month period beginning in June 2018. We suppose that the September Eurodollar futures quote is 99.75, implying that the buyer will lock the interest rate at 100 – 99.75 or 0.25 percent. After three months, LIBOR turns out to be 0.17 percent. The final settlement of the contract would then be at a price of 99.83.
This indicates a profit of 16 ticks. (1 tick = 0.005 price points)
-> 99.83 – 99.75 = 0.08
-> 0.08/0.005 = 16
Each tick amounts to $12.50. This implies that a trader made a $200(12*12.50) profit from the contract.
It basically means that the potential LIBOR rate was projected to be 0.25% during the duration of the deal. The lender spends $1 million and expects the borrower to pay a 0.25% interest on completion of the deal. But the real LIBOR rate happens to be 0.19 percent. This means that the creditor must pay an extra sum to settle the contract and therefore incur a loss. The investor gets more return on the investment as a result of the terms of the deal, thereby making a profit.
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Benefits of Eurodollar
The profits tend to have accrued to the countries involved in the euro-dollar economy are:
- It has created a foreign short-term capital market, due to the high degree of liquidity of the Euro-dollars.
- Euro-dollars are valuable for funding overseas trade.
- Euro-dollars have made it easier for financial firms to have more ability to change their currency and liquidity levels
- It has allowed importers and exporters to borrow dollars to fund trade at cheaper rates than would otherwise have been feasible.
- It has also contributed to increasing the profit margins between the savings rate and the lending rate.
- It has increased the volume of funds available for arbitration.
- It has made it possible for monetary authorities with low savings to raise their savings by borrowing euro-dollar deposits.
Author: Abhay Kanodia
About the author: An undergraduate student from the Birla Institute of Technology and Sciences, Pilani(BITS Pilani). Exploring the fields of finance and data analytics and its applications in other different domains.