The Eurodollar Market

Plan for this lecture

I. Introduction to the terminology and

conventions surrounding bonds,
especially U.S. Treasury securities.
II. Zero coupon bonds and coupon bonds
III. Strips
IV.Bond quotes
The Basics of the Eurodollar Market

➢ What is it?
➢ A loan market for US$ denominated borrowing and lending
(US$ CD deposits are received and US$ denominated loans
extended) based outside the United States.
➢ This is a larger interest rate market than the US Treasury
market.
➢ Eurodollars can be invested with various investment horizons, at the
USD denominated London-Interbank-Offer-Rate (LIBOR).

➢ Where is it based?
➢ It is based primarily in London, but also in the Cayman Islands,
Tokyo, and Hong Kong.
➢ Similar offshore markets exist for other currencies, e.g., the
pound, yen, etc.
How Do Balances Get Created?
An Example
➢ Suppose General Electric receives $1,000,000 from the
sale of a transformer and deposits the money in a
checking account at JP Morgan Chase in New York.
➢ It might then purchase a 6-month $1,000,000 Eurodollar
CD from HSBC in London where it remains as a dollar
deposit (not exchanged into an equivalent amount of
pounds).
➢ This money, aside from any reserve requirement HSBC
may wish to impose on itself, can then be loaned out to
firms who wish to take out dollar-denominated loans.
➢ This entire system of taking dollar deposits in London
and lending them primarily from London is referred to as
the Eurodollar market.
Eurodollar Market: Relative Size and
Importance of US Residents

5
 Incentives for Banks and Depositors to
Keep Money Outside the US
➢ Since these are dollar deposits the Bank of England monetary
authority has no power to regulate them.
➢ There is no required FDIC insurance premium to be paid on
aggregate time deposits (these are mostly CDs; in the U.S. this
insurance costs 12 cents per $100 time deposit)
➢ There is no reserve requirement on Time Deposits (in the U.S.
5% of CD deposits must be held back as reserves at the FED in a
non-interest bearing account).
➢ No state and local taxes to be paid. It may also be that until
profits are remitted to the US, no federal income tax is imposed
on them.
➢ With these cost reductions, the London based banks operating in
the Eurodollar market can offer higher deposit rates, but they
have to as Eurodollar deposits are not guaranteed.
Incentives for Borrowers to Keep Money
Outside the US
➢ With low regulation, many banks participate in this market
with the result that it is highly competitive.
➢ As a result loan agreements can be executed very quickly, and
the competition results in relatively low lending margins
(borrowing costs).
➢ In addition, the amount of capital available is enormous
allowing very large loans to be syndicated easily and quickly.
 The Nature of the Loans Made in the
Eurodollar Market
➢ Eurodollar loans are exclusively floating rate loans, with an
interest rate reset period of at most 6 months.
➢ Loans in this market are generally extended only to first tier
industrial firms and financial institutions.
➢ Because of the floating rate feature, the duration of the loans,
which are the assets of the banks, is at most 0.5 year.
Consequently, the borrower bears all associated interest rate
risk.
➢ Eurodollar credit markets offer the full range of loan types
➢ Euro-commercial paper loans (short term Eurodollar notes
issued by firms which come due in less that 365 days)
➢ Stand-by Credit Facilities (this is a commitment to lend a
specific amount at the borrower’s request at any time over a
pre-specified period)
➢ Eurodollar loans (long term floating rate loans from one to 30
or more years).
 LIBOR is the Benchmark Rate for the
Eurodollar Market (until 2021)
➢ LIBOR (the London Interbank Offer Rate) is the rate at
which large banks in the Eurodollar market extend loans to
one another. It is a rate for which the borrowing bank may
default (one of these banks could conceivably fail and not
discharge is loan commitments to another bank. This
possibility is no longer remote).

➢ LIBID is the deposit rate—what bank A would pay to bank B

for B’s deposit in A.

➢ Banks are always lending money to one another; in the

domestic US, the rate at which this occurs is referred to as the
Federal Funds rate.
 Who Uses LIBOR as a Benchmark?
➢ Many markets -even the variable rate US mortgage market -are
benchmarked from the Libor rate. This means that many
other loans/bonds issued all over the world have terms that
allow their interest rate to be reset every 6 months at a rate
equal to the 6 month Libor rate for that 6 month period plus
some premium or spread.

➢ For example, Chrysler borrowed $20B from banks in the

Eurodollar market with the rate indexed to 6-month Libor.
➢ At the end of 2007, the net loans outstanding in the
Eurodollar market was on the order of $28.5 Trillion. By
“net” we mean after subtracting the loans that participating
banks have made to one another.
 LIBOR is a Defaultable Rate
rFF SFF rLIBOR
SBanks
Eurodollars

e
rLIBOR
e
rFF
DBanks
Eurodollars
DFF

➢ Since counter-parties do not have he credit quality of the US

government, LIBOR contains a positive spread to the
corresponding, i.e., same maturity, U.S. Treasury rate.

➢ Since LIBOR is a defaultable rate it should be above the

corresponding Federal Funds rate.

11
 How is the Libor Rate Generated?

➢ The British Bankers Association basically polls a select panel

of 16 banks, active in the Eurodollar market, and asks them
what rates they would charge to lend money to other member
banks. As of the middle of last year, the panel of banks
consulted for US$ (Eurodollar) rates were:

➢ Only a few of the banks are US based ones; most are European
based and there is some concern that it gives European banks
too much influence over rate setting in the United States.
13
 LIBOR After Financial Crisis
Libor spiked as
5% banks began to see
risks in lending to
4 one another.

3
2.34%
2

0
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
TED Spread January 2006-June 2008

1.8

1.6

1.4

1.2

0.8

0.6

0.4

0.2

0
9/30/05 12/14/05 2/27/06 5/13/06 7/27/06 10/10/06 12/24/06 3/9/07 5/23/07 8/6/07 10/20/07 1/3/08 3/18/08 6/1/08

➢ How large is the default premium on LIBOR?

➢ TED spread: 6-month LIBOR minus 6-month Treasury.
15
How is a Eurodollar Loan to a Corporate
Client Structured?

𝑟𝑎𝑡𝑒 = 6 𝑚𝑜𝑛𝑡ℎ𝑠 𝐿𝐼𝐵𝑂𝑅 + 𝑠𝑝𝑟𝑒𝑎𝑑 (𝑞𝑢𝑜𝑡𝑒𝑑 𝑖𝑛 𝑏𝑎𝑠𝑖𝑠 𝑝𝑜𝑖𝑛𝑡𝑠)

➢ The spread will be proportional to the credit rating of the

client

➢ With a six-month reset, such a loan represents a low duration

asset of the lending institution (𝐷𝑙𝑜𝑎𝑛 = 0.5 𝑦𝑒𝑎𝑟𝑠), so there
is little interest rate risk to the lending institution.

➢ Borrowers bear all the risk.

 Example: Loan Based on the 6
Months LIBOR
➢ Amount of Loan: $100,000,000
➢ Terms: LIBOR + 50 basis points (0.5%)

Time 𝒕 = 𝟎 6 months 1 year 1.5 year 2 years

6 mo. LIBOR
rate 0.02 0.025 0.031 0.033

Loan rate
0.025 0.03 0.036 0.038

End of Period
Payment by 2.5 M 3M 3.6 M 3.8 M
Borrower (payments are made at end of the period)
 How Do Borrowers Hedge Their
Interest Rate Risk?
▪ Eurodollar futures and forward contracts represent available
tools for this purpose.
▪ What if a borrower wishes to remove this risk on a regular
basis?
– A swap contract accomplishes this.
 Hedging with Eurodollar Futures: An
Introduction
➢ How to use Eurodollar futures contracts as a hedging
instrument for bond portfolio insurance?

➢ The concept is identical to the prior use of T-bill futures: the

investor desiring to hedge must write Eurodollar futures in the
appropriate numbers. These written contacts will become more
valuable as rates rise (prices fall).

➢ Aside from a few details/conventions of measurement, the

calculations mimic those of T-bill futures.
ED Futures Data from Bloomberg

Expiration
Date

Price
 ED Futures Data from CME

Prior
Month Options Charts Last Change Settle Open High Low Volume Updated
16:39:21
Show
OCT OCT CT
Price 97.9375 +0.015 97.9225 97.925 97.94 97.9225 41,421
2019 2019 27 Sep
Chart
2019
16:39:22
Show
NOV NOV CT
Price 98.00 +0.005 97.995 97.995 98.01 97.985 23,284
2019 2019 27 Sep
Chart
2019
16:39:22
Show
DEC DEC CT
Price 98.03 +0.01 98.02 98.015 98.045 98.005 216,502
2019 2019 27 Sep
Chart
2019
16:39:22
Show
JAN JAN CT
Price 98.16 +0.01 98.15 98.14 98.165 98.14 2,136
2020 2020 27 Sep
Chart
201
How to interpret the Eurodollar FP (futures
price), and how the contract works
➢ Suppose we transacted one January 2020 ED futures contract
at a current FP = 98.16 (futures price) on September 28, 2019
September 28, 2019 T = January 2020 April 2020
𝒕=𝟎 𝑻 + 𝟎. 𝟐𝟓
Transacted a contract Expiration Date
Underlying
at 𝐹𝑃 = 98.16
LIBOR
𝒇𝑳𝑰𝑩𝑶𝑹
𝟎.𝟐𝟓 = 𝟎. 𝟎𝟏𝟖𝟒 Forward
Rate
➢ We interpret 98.16 as identifying the (annualized!) forward 3
month LIBOR rate relative to January 2020 as being
100 − 98.16 = 1.84% 𝑜𝑟 0.0184
➢ The contract amount is $1,000,000 for 3 months.
 Eurodollar Futures: LIBOR Drops
➢ Suppose you signed (went long) in a futures contract when FP
= 98.16, and during the life of the contract, the FP rises to 99
(forward LIBOR falls to 1%); then:
Long Position Receives Short Position Receives
𝟗𝟗 − 𝟗𝟖. 𝟏𝟔 𝟗𝟗 − 𝟗𝟖. 𝟏𝟔
𝟏, 𝟎𝟎𝟎, 𝟎𝟎𝟎 × × 𝟎. 𝟐𝟓 −𝟏, 𝟎𝟎𝟎, 𝟎𝟎𝟎 × × 𝟎. 𝟐𝟓
𝟏𝟎𝟎 𝟏𝟎𝟎
= $𝟐, 𝟏𝟎𝟎 = −$𝟐, 𝟏𝟎𝟎

➢ There is only cash settlement

 Eurodollar Futures: LIBOR
Increases
➢ Suppose at some point, the FP falls to 97 (forward LIBOR
rises to 3%, annualized); then,

Long Position Receives Short Position Receives

𝟗𝟕 − 𝟗𝟖. 𝟏𝟔 𝟗𝟕 − 𝟗𝟖. 𝟏𝟔
𝟏, 𝟎𝟎𝟎, 𝟎𝟎𝟎 × × 𝟎. 𝟐𝟓 −𝟏, 𝟎𝟎𝟎, 𝟎𝟎𝟎 × × 𝟎. 𝟐𝟓
𝟏𝟎𝟎 𝟏𝟎𝟎
= −$𝟐, 𝟗𝟎𝟎 = $𝟐, 𝟗𝟎𝟎

➢ As with any of our hedging instruments (T-bonds, T-bill

futures), short positions in Eurodollar futures increase in value
as rates rise
Example 1: Hedging Interest Expenses
with Eurodollar Futures
➢ Your problem: you will need to borrow $10M for 3 months,
and you will need the loan 4 months from now. Your firm is
sufficiently secure financially that you can effectively borrow
at LIBOR.

➢ Currently, forward LIBOR (3 month rate) is 5.14% relative to

t = 4 months (0.33 year). This corresponds to FP = 94.86.
𝒕=𝟎 𝒕 = 𝟒 𝒎𝒐𝒏𝒕𝒉𝒔
𝐹𝑃 = 94.86 𝐿𝐼𝐵𝑂𝑅
0.33𝑓0.25 = 0.0514

4 months 3 months
Example 1: Hedging Interest Expenses
with Eurodollar Futures
➢ You would like to lock in this rate so that you will know what
your future loan cost will be. If 5.14% can be locked in, your
cost will be:
0.0514 × 0.25 × 10,000,000 =$128,500

Rate Number Amount of

Annualized of Years the Loan

➢ To lock it in, write 10 Eurodollar futures contracts at FP =

94.86 (corresponds to 5.14%).
 Example 1: Hedging Interest
Expenses with Eurodollar Futures
▪ At t = 0.33 years, suppose LIBOR has risen to 6.14% (futures
price falls to 93.86)
Payoff to Short Position Cost of the Loan at the New
Rate
𝟏𝟎 𝒄𝒐𝒏𝒕𝒓𝒂𝒄𝒕𝒔 × 𝟏, 𝟎𝟎𝟎, 𝟎𝟎𝟎 𝟏𝟎, 𝟎𝟎𝟎, 𝟎𝟎𝟎 × 𝟎. 𝟎𝟔𝟏𝟒 × 𝟎. 𝟐𝟓
𝟗𝟑. 𝟖𝟔 − 𝟗𝟒. 𝟖𝟔 = $𝟏𝟓𝟑, 𝟓𝟎𝟎
× × 𝟎. 𝟐𝟓 = $𝟐𝟓, 𝟎𝟎𝟎
𝟏𝟎𝟎

▪ The net cost is

$153,500 − $25,000 = $128,500

Gain on
Short Futures
 Questions about Example 1

1. Suppose the loan rate for you is LIBOR + 1%;

would this affect the number of contracts you
write?

2. What rate changes can you insure against

using Eurodollar futures? What rate changes
can you not insure against?
 Example 2: Hedging a Bond Portfolio
with Three-Month LIBOR Futures
➢ Consistent with our hedging context, suppose the term
structure is flat. The “Term structure of LIBOR rates” and the
“forward LIBOR curve” would be essentially flat as well.

➢ You own $10M of bonds of 𝐷𝑝𝑓 = 6 years when the interest

rate (LIBOR) environment is flat at 𝑟 = 5.14%. You are
concerned that rates may rise by 0.5%. Hedge your position
with Eurodollar futures.

➢ What is the loss if you do not hedge?

𝐷𝑝𝑓 6
∆𝑉𝑝𝑓 ≈ − 𝑉𝑝𝑓 ∆𝑟 = − × 10,000,000 × 0.005
1+𝑟 1.0514
= −$285,334
 Example 2: Hedging a Bond Portfolio
with Three-Month LIBOR Futures
➢“Perfectly” hedging using Eurodollar futures means 𝐷𝑝𝑓 = 0.
How many contracts would you write to bring this about?

𝑉𝑝𝑓 𝐷𝑝𝑓 = 𝑛1 𝑃1 𝐷1 + 𝑛𝐸𝐷𝐹 𝐷𝐸𝐷𝐹 × $1,000,000

You receive gains

and losses
relative to $1M
−10,000,000 × 6
𝑛𝐸𝐷𝐹 = = −240 𝐶𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑠
0.25 × 1,000,000

➢ Write 240 contracts.

 Example 2: Hedging a Bond Portfolio
with Three-Month LIBOR Futures
➢ Suppose rates do rise as feared
Loss on 6
− × 10,000,000 × 0.005 = −$285,334
the 1.0514
Portfolio

Gain on 94.36 − 94.86

−240 × 1,000,000 × 0.25 × = $300,000
the 100
Futures
0.005
Total +$15,000

➢ We are slightly over-hedged, as theory reminds us must be the

case.
 LIBOR Scandal
➢ Following the crisis, several large banks and their CEOs were
implicated in LIBOR manipulation.

➢Manipulation included:
➢Reporting low rates to make
banks look stronger
➢Reporting false rates to profit
on LIBOR-based financial
products.

Figure: Libor Rigging Scandal - quote from anon Barklays trader.

Source: Wiki
 LIBOR Scandal
➢ Potential for LIBOR manipulation is amplified by the thinness
of the market on which this rate is based.

➢ Post-crisis, banks have significantly reduced their short-term

unsecured borrowing. In 2018, only six or seven transactions
occurred in the one- and three-month tenors at banks on the
dollar LIBOR panel, with even fewer transactions at longer
tenors
 New Reference Rates – Desirable
Features
A good reference rate should:
➢ Provide a robust and accurate representation of interest rates in
core money markets That is not susceptible to manipulation.
➢ Offer a reference rate for financial contracts that extend
beyond the money market. Such a reference rate should be
usable for discounting and for pricing cash instruments and
interest rate derivatives.
➢ Serve as a benchmark for term lending and funding. Financial
intermediaries are both lenders and borrowers, they require a
lending benchmark that behaves not too differently from the
rates at which they raise funding.
LIBOR Phase-Out: Potential
Candidates

Source: A. Schrimpf and V. Sushko, “Beyond LIBOR: a primer on the new reference
rates,” (2019), BIS publication.
 Conclusions

➢ We have illustrated the use of Eurodollar futures as a

hedging instrument, even in the case of a T-bond
portfolio.
➢ Notice an implicit assumption, however: LIBOR and UST
rates for the same maturity instruments (their respective
term structures must move in lockstep): a 0.5% increase
in LIBOR rates must accompany a 0.5% increase in T-bill
rates. If this relationship breaks down, the hedge will
become less effective.
 Further Reading

➢ https://www.wsj.com/articles/companies-give-investors-a-
peek-at-life-after-libor-11551528000
➢ https://www.nytimes.com/2018/07/19/business/libor-future-
2021-phase-out.html
➢ https://www.bis.org/publ/qtrpdf/r_qt1206f.pdf