5

Eurodollar Futures, and

Forwards

In this chapter we will learn about

• Eurodollar Deposits

• Eurodollar Futures Contracts,

• Hedging strategies using ED Futures,

• Forward Rate Agreements,

• Pricing FRAs.

• Hedging FRAs using ED Futures,

• Constructing the Libor Zero Curve from ED deposit rates and ED Fu-
tures.

5.1 EURODOLLAR DEPOSITS

As discussed in chapter 2, Eurodollar (ED) deposits are dollar deposits main-

tained outside the USA. They are exempt from Federal Reserve regulations
that apply to domestic deposit markets. The interest rate that applies to
ED deposits in interbank transactions is the LIBOR rate. The LIBOR spot
market has maturities from a few days to 10 years but liquidity is the greatest
69
70 CHAPTER 5: EURODOLLAR FUTURES AND FORWARDS

Table 5.1 LIBOR spot rates

Dates 7day 1mth. 3mth 6mth 9mth 1yr

LIBOR 1.000 1.100 1.160 1.165 1.205 1.337

within one year. Table 5.1 shows LIBOR spot rates over a year as of January
14th 2004.
In the ED deposit market, deposits are traded between banks for ranges of
maturities. If one million dollars is borrowed for 45 days at a LIBOR rate of
5.25%, the interest is

45
Interest = 1m × 0.0525 = $6562.50
360

The rate quoted assumes settlement will occur two days after the trade.
Banks are willing to lend money to firms at the Libor rate provided their
credit is comparable to these strong banks. If their credit is weaker, then the
lending bank may quote a rate as a spread over the Libor rate.

5.2 THE TED SPREAD

Banks that offer LIBOR deposits have the potential to default. The 3 month
LIBOR rate will therefore be set higher than the 3-month Treasury rate,
with the spread between the two rates representing a premium for default.
This Treasury-Eurodollar spread, called the TED spread fluctuates with time.
When the economy is sound, spreads may be fairly small, but in times of crises,
the spreads can be fairly large. The range in spreads can typically be between
30 to 300 basis points.
A firm that borrows funds over time will typically face interest rates more
highly correlated with LIBOR than with Treasury rates. Hence, rather than
use futures contracts on Treasuries as a hedge, firms typically will look to
hedge short term rates using Eurodollar (ED) futures.
 CHAPTER 5: 90 DAY EURODOLLAR FUTURES 71

5.3 90 DAY EURODOLLAR FUTURES

The 90 day LIBOR rate is the yield derived on a 90 day ED deposit. ED

futures contracts that settle to a 90 day LIBOR rate are very actively traded.1
The underlying security is a $1, 000, 000 90-day Libor deposit. The futures
contracts available mature in March, June, September and December of each
year and extend out for about 10 years. In addition, the four nearest contract
months also trade. The ED futures contract settles by cash on its expiration
date, which is the second London business day before the third Wednesday
of the maturity month. On the expiration date, the final settlement price is
determined by the clearing house using the following procedure. At the close
of trading, a sample of 12 banks from a list of no more than 20 participating
banks is randomly selected. These banks provide a quotation on 3 month
LIBOR deposit rates. The clearing house eliminates the lowest 2 and highest
two quotes, and takes the arithmetic average of the remaining 12 quotes. This
procedure is repeated at a random time within 90 minutes. The average of
these two prices determines the final LIBOR rate. The final settlement price
is established by subtracting this rate from 100. The average is rounded to the
nearest 1/10000th of a percentage point, with decimal fractions ending in a
five rounded up. For example, an average rate of 8.65625% would be rounded
to 8.6563 and then subtracted from 100 to determine a final settlement price
of 91.3437.
Let t0 be the expiration date of the futures contract, and let `[t0 , t1] be
the LIBOR rate, expressed in annualized decimal form, at date t0 . Since the
settlement date is two days later, the rate `[t0, t1] actually represents the rate
from date t0 + 2 and t1 would be 90 days later. The final quoted futures index
price is
F U (t0) = 100[1 − `[t0, t1]].

Let F U (t) be the quoted index futures price at an earlier date t, t < t0.
The implied LIBOR interest rate is [100 − F U (t)]%, or in decimal form:
F U (t)
I`t [t0, t1] = 1 −
100
Thus, a futures index of 92 corresponds to an implied interest rate of 8%, or
I`t [t0 , t1] = 0.08.
The actual or effective dollar price of the contract differs from the index
because the yield is divided by four, so as to reflect a three month rate.
I`t [t0 , t1]
Effective Price = 1m × (1 − )
4

1 The futures contract traded on the CME is one of the most actively traded futures contracts
in the world.
72 CHAPTER 5: EURODOLLAR FUTURES AND FORWARDS

Example
A trader buys a Eurodollar futures price at 92.0 and sells it the same day at
92.08. The change of 8 basis points causes a price change of $200. Specifically,
the profit to the long is given by:
0.0792 0.080
1m × (1 − ) − 1m × (1 − )
4 4
0.0800 − 0.0792
= 1m × ( )
4
= 1m × 0.0002 = $200.

Thus each basis point change in the annualized implied LIBOR rate is worth
$25.

A long position in a ED futures contract is really just a short position on

the 90 day LIBOR interest rate. In the last example the implied LIBOR rate
decreased by 8 basis points, from 8.0% to 7.92%, leading to a profit on the
long position of 8 × 25 = $200. A trader who sells ED futures, profits if rates
increase.
ED futures contracts that trade on SIMEX use the CME’s final settlement
price. These two exchanges designed a system that permits futures contracts
traded on SIMEX to be completely interchangeable with contracts that trade
on the CME. The contract specifications on both exchanges are identical ex-
cept for trading hours. However, a contract that trades on the floor of the
CME can be transferred through the mutual offset system to SIMEX, and
cancelled there. Similarly, a contract traded on the floor of SIMEX can be
transferred to the CME. As a result, the trading hours of these contracts
extends beyond the trading hours of either exchange.
Table (5.2) shows the ED futures contracts that traded on January 15th
2004. The cash settlement date for each contract is indicated as well as the
gap, measured in days, between successive expiration dates. The settlement
price is indicated, and information from the previous day is supplied.
Notice that actively traded ED Futures contracts exist with settlement
dates that extend beyond 5 years. This is quite unusual. In most futures
markets, liquidity drops off very rapidly with maturity. The reason for high
liquidity even in distant contracts relates to the use of these contracts as
hedges for FRAs, Interest Rate Swaps, and other derivatives. This will be
discussed later.
As an example, consider the June 2005 contract. The current implied Libor
rate for this contract is 100 − 97.315 = 2.685%. A speculator who thinks that
the 90 day spot Libor rate beginning from the June 2005 expiration date will
be much higher than this number might consider selling this futures contract.
 CHAPTER 5: 90 DAY EURODOLLAR FUTURES 73

Table 5.2 Eurodollar Futures Information: January 15th 2004

A plot of these successive 90 day implied futures rates against time, pro-
duces a curve that, in this case, rises from 1.125% to 6.66%. If we incorrectly
assumed that these futures rates were equal to forward rates, then we could
construct a LIBOR yield curve or a LIBOR discount bond curve.
74 CHAPTER 5: EURODOLLAR FUTURES AND FORWARDS

5.4 CONSTRUCTING THE LIBOR DISCOUNT FUNCTION

In Table (5.2), the first ED futures contract expires in 60 days. Assume

1
the 60-day spot LIBOR rate was 1.16%. Then, if (1+0.016×60/360) = 0.99807
dollars were placed in a ED deposit, after 60 days this would be worth $1.0.
This discount factor is recorded in the second last column of the table. By
selling the March futures contract, the trader locks into a rate of 1.160% for
the period from March to June. The implied discount factor for that period
1
is therefore (1+0.016×91/360) = 0.99708. The discount factor from January
15th 2004 to 14th June 2004 is therefore the product of this number with the
previous discount factor. This value, 0.99515 is indicated in the second row
of the last column.
In general, then, given the discount factor up to date tj is P (0, tj ), and
given the implied ED futures rate for the next period [tj , tj+1], we compute
the discount factor up to date tj+1 as follows:
1
P (0, tj+1) = P (0, tj )
(1 + I`[tj , tj+1] × (tj+1 − tj )/360)

The resulting plot of these values against maturity constitute the LIBOR
discount function.
The above analysis would be precise is the implied futures rates were for-
ward rates. Recall that forward prices (rates) are NOT equal to futures prices
(rates ) when interest rates are uncertain. The computation of forward rates
from these futures rates requires an adjustment downward.
To see that a downward adjustment is necessary, recall that futures con-
tracts are resettled daily. This resetlement process implies that there are daily
cash flows into and out of the ED futures account. Consider a long position
in the futures contract. When rates drop, the futures price increases, produc-
ing cash inflows. Unfortunately, these profits are reinvested at the lower rate.
Conversely, when rates rise, the long position will lose money, and these losses
have to be financed at higher rates. The negative impact of these reinvest-
ments and borrowings must be compensated by a lower initial contract price,
relative to the more advantageous forward contract. Lower ED futures prices
imply higher initial ED implied rates.
The magnitude of the adjustment, referred to as the convexity adjustment,
can be quantified and is the topic of a future chapter. The magnitude of the
adjustment depends on the volatility of spot LIBOR and on the maturity of
the futures contract. A very good approximation to the adjustment is given
by the formula:
T2 T
Adj = 10, 000 × σ2 ( + ).
2 8
This adjustment is in basis points. The volatilty, σ is typically less than 0.01.
The maturity, T, is measured in years from the current date to the expiration
 CHAPTER 5: CONSTRUCTING THE LIBOR DISCOUNT FUNCTION 75

date of the futures. Using this value the downward adjustment to the implied
futures rate for all our ED futures contracts are shown in Table (5.3).

Table 5.3 Eurodollar Futures Information: January 15th 2004

If the maturity is less than one year, the magnitude of the difference is usu-
ally less than a basis point. However, for longer dated contracts the convexity
76 CHAPTER 5: EURODOLLAR FUTURES AND FORWARDS

affect can be fairly significant. For example, for a ten year contract, a ball
park adjustment is of the order of about 50 basis points. In comparing the
two discount factors from the two tables, the impact of the adjustment can
be seen.
We now illustrate how ED futures can be used to hedge against unantici-
pated interest rate movements.

Hedging Against Interest Rate Increases

Consider, the following problem. A bank provides a firm a three month loan
of $1m starting in 3 months at the LIBOR rate at the start of the loan. Let
t0 = 14 be the start date and t1 = 12 the final payment date. The interest
expense on this loan, due in 6 months is $1m × `[t04,t1 ] .
Lets consider what happens if the firm sells 1 ED futures contract, with an
expiration date of 3 months. Ignoring the timing of cash flows due to marking
to market, the profit from selling 1 ED futures contract at t0 is π(t0 ), where

`[t0, t1] I`0 [t0, t1]

π(t0 ) = $1m × [ − ]. (5.1)
4 4
The net effective interest expense is therefore:

`[t0, t1] `[t0, t1] I`0 [t0, t1] I`0 [t0, t1]
$1m × − $1m × [ − = $1m × .
4 4 4 4
Hence, by selling ED futures contracts, the firm exchanges an uncertain fund-
ing cost with a certain funding cost equal to the implied ED futures rate.
Actually, the above analysis is only approximate, since we ignored the
timing of cash flows. First, the profit from the sale of the futures contract,
given by equation (5.1), occurs at time t0 while the interest expense on the
loan occurs at time t1. Second, we ignored the fact that with futures cash
flows occur over the life of the contract, from date 0 to date t0 .
To fix the first timing problem, assume rather than selling 1 futures con-
tract, we sold Q contracts. Then, if we assume that the profit (negative, if
a loss) is invested in the ED market over the period [t0, t1], at date t1 it will
have grown to:

`[t0 , t1] `[t0, t1] I`0 [t0, t1]

π(t1 ) = Q(1 + ) × $1m × [ − ].
4 4 4
The net interest rate expense of the loan with hedging consists of the actual
interest, less the profit from selling the futures, and is given by C(t1 ), where

`[t0 , t1] `[t0 , t1] `[t0, t1] I`0 [t0, t1]

C(t1) = $1m × − $1m × Q(1 + )×[ − ]
4 4 4 4
 CHAPTER 5: CONSTRUCTING THE LIBOR DISCOUNT FUNCTION 77

Now, at date 0, if we knew the future LIBOR rate, `(t0 , t1), then by choosing
Q = (1+`(t01,t1)/4) , the net interest expense with hedging would simplify to:
I`0 [t0, t1]
C(t1 ) = $1m × .
4
Unfortunately, at date 0, we do not know `(t0 , t1), so we cannot compute it
exactly, but we may be able to estimate it well by the implied futures rate
I`0 (t0 , t1). Then Q = (1+I`0 (t10 ,t1)/4) . Other than the issue of estimating Q,
we have resolved the first part of the timing mismatch.
The second mismatch comes from the fact that we have really assumed
the contract was a forward contract rather than a futures contract. Recall
that futures contracts provide daily cash flows, over the period [0, t0], whereas
forwards only provide this cash flow at the delivery date. The payoff from one
forward contract with settlement date t0 held over a day can be replicated
by a trading strategy involving trading P (0, t0) otherwise identical futures
contracts.
To see this, assume at date 0, a forward contract is sold. Assume fur-
ther that P (0, t0) futures were purchased. The next day the P (0, t0) futures
position is liquidated for a profit equal to:
P (0, t0) × ( Change in Effective Futures Price).
Now consider the change in value of a single forward contract held over one
day. Since the change in the forward price is only obtained at the delivery
date, the value associated with the change in forward price equals the present
value of the change, or:
P (0, t0) × ( Change in Effective Forward Price)

If rates were certain, forward prices changes would equal futures price
changes, so the daily profit from holding P (0, t0) futures contracts equals
the profit from holding 1 forward contract over one day. When interest rates
are uncertain, assuming equality is only an approximation. Hence, to adjust
for the marking to market feature rather than use 1 contract, we should use
P (0, t0) contracts.
Combining the timing effect and the marking to market effects together,
results in lowering the hedge ratio from 1 to a hedge ratio of HR = Q×P (0, t0).
1
Substituting for Q and taking P (0, t0) = 1+`(0,t 0 )/4
, we obtain:
1 1
HR = ×
(1 + I`0 (t0, t1)/4) 1 + `(0, t0 )/4
If we assume away the difference between implied futures rates and forward
rates, then the right hand side represents the value at date 0 of a Eurodollar
deposit that pays out $1 at date t1 . That is
HR = P (0, t1)
78 CHAPTER 5: EURODOLLAR FUTURES AND FORWARDS

In summary, if ED futures were used to hedge against increasing LIBOR

rates, rather than implementing a naive hedge, the number of ED futures to
sell should be reduced by the present value factor between the current date,
and the date where the interest rate loan is to be paid back. As time evolves
the discount factor increases towards one, and the hedge strategy converges
towards selling 1 futures contract.

Example: Using ED Futures to Hedge a Floating Rate Liability

(i) It is currently October 15th 2004. A firm plans on borrowing $100
million dollars on September 13th 2004 and pay back the loan after 3 months.
The interest on the loan is tied to 3 month LIBOR at the start date. Interest
rates are currently fairly low, and the firm is concerned that rates will rise
dramatically. A naive hedge would be to sell 100 ED futures contracts that
settle in September. Using the data from Table (5.3) this would lock in an
implied futures rate of 1.53%. From Table (5.3) the appropriate discount
factor to use is given by 0.988, so a slightly better hedge would involve selling
99 contracts. Note that as the time of the borrowing increases, and as interest
rates increase, the difference between the naive and adjusted hedge increases.
(ii) A firm has floating rate liabilities of $1m indexed off 90 day LIBOR
with payment dates that coincide with the maturity dates of ED futures. The
firm is concerned that LIBOR rates will increase and would like to lock into
a fixed set of rates using a naive hedge.
The current ED futures prices are given in Table 5.4. By selling a portfolio

Table 5.4 ED Futures Prices

Date Futures Price Implied LIBOR

March (t0 ) 96.54 3.46
June (t1) 96.35 3.65
Sept (t2) 96.14 3.86
Dec (t3 ) 96.00 4.00

of futures contracts with consecutive expiration dates, called a strip of futures,

the firm can convert its floating rate liabilities into a sequence of fixed rate
liabilities.
Assume the firm sells a strip of futures with March, June, September and
December expiration dates. The actual LIBOR rates that occur on the expi-
ration dates are shown in the second column of the table below.
h i
Recall that the profit from selling one futures contract is $1m× `[t04,t1] − I`0 [t40 ,t1] .
 CHAPTER 5: CONSTRUCTING THE LIBOR DISCOUNT FUNCTION 79

Table 5.5 shows the differences between the actual and implied LIBOR
rates and the profit on the sale of each contract. Since each basis point is
worth $25, the final column is obtained by mutiplying the previous column
by 25

Table 5.5 Profit form Sale of ED Futures Contracts

Date Actual LIBOR Basis Point Increase Profit on Futures

(LIBOR-Implied LIBOR)100
March (t0 ) 4.00 54 1,350
June (t1) 4.20 55 1,375
Sept (t2 ) 4.20 34 850
Dec (t3 ) 3.50 -50 -1,250

The final interest expenses of the unhedged and hedged positions are shown
below.

Date Unhedged Hedged

t0 Interest = 10,000 Interest = 10,000
Hedging Cost = - 1,350
Net Expense = 8650
Effective Rate 4% Effective Rate 3.46%

t1 Interest = 10,500 Interest = 10,500

Hedging Cost = - 1,375
Net Expense = 9125
Effective Rate 4.2% Effective Rate 3.65%

t2 Interest = 10,500 Interest = 10,500

Hedging Cost = - 1,375
Net Expense = 850
Effective Rate 4.2% Effective Rate 3.86%

t3 Interest = 8,750 Interest = 8750

Hedging Cost = 1,250
Net Expense = 10000
Effective Rate 3.5% Effective Rate 4%
80 CHAPTER 5: EURODOLLAR FUTURES AND FORWARDS

Notice that by hedging, the interest expenses are exactly equal to the im-
plied ED futures LIBOR rates. The strip of futures converts the uncertainty
of LIBOR rates into the set of certain ED implied futures rates.
To expedite the execution of strip trades, the CME offers bundles and
packs. A bundle is a strip of futures contracts in consecutive series. A five
year bundle, for example, consists of 20 ED futures contracts. Bundles are
quoted on the basis of the net average price change of the contracts in the
bundle. A pack is a bundle that consists of 4 contracts in each series, rather
than 1.
Of course, in this example we have acted as if the futures contracts were
forward contracts and we have not tailed the hedge. The consequences of
tailing the hedge would result in a slightly smaller sale of strips.

5.5 ROLLING HEDGES

The above strategy of selling a strip of ED futures contracts to hedge a floating

rate liability works well if there is sufficient liquidity in the distant ED futures
contracts. Since ED futures contracts are liquid contracts, even for distant
maturities, the trading of strips is very popular. If the hedge has to extend
out over time periods where actively traded ED futures contracts do not exist,
then an alternative hedging scheme can be established. In this case, a hedger
can set up a rolling hedge. This is best illustrated with an example. As in
our earlier example, we will, for the moment, ignore the difference between
forward and futures contracts.

Example
A firm is scheduled to use 3 month borrowing for which it pays a rate
linked to 3 month LIBOR. Assume the borrowing periods coincide with the
settlement dates of succesive ED futures contracts. In particular, assume the
firm’s needs are 20m dollars in March, 40m dollars in June, 20m dollars in
September and 50m dollars in December.
To hedge against LIBOR rates increasing, the firm could sell the appropri-
ate strip of ED futures. A naive one for one hedge is

• sell 20 March ED futures

• sell 40 June ED futures

• sell 20 September ED futures

• sell 50 December ED futures.

 CHAPTER 5: FORWARD RATE AGREEMENTS 81

A better dynamic hedge would require selling less ED futures. Assume the
LIBOR discount function is given below:

Date of Loan Time to Maturity Discount Factor

March 1.0 0.962
June 1.25 0.951
Sept. 1.50 0.939
Dec. 1.75 0.919
March 2.00 0.900

In tailing the hedge, the number of ED futures contracts are reduced to

0.951 × 20 = 19 March contracts, 40 × 0.939 ≈ 37 June contracts, 20 × 0.919 ≈
18 September contracts, and 50 × 0.90 = 45 December contracts. Over time
these hedges need to be increased.
If the distant contracts were not that liquid, another strategy could be
adopted. To get the basic idea, we first ignore the tailing, and reconsider a
naive rolling hedge. The total number of dollars to be borrowed is 20m+40m+
20m + 50m = 130m dollars. At the initiation date, 130 March ED futures
contracts are sold. Then, in early March, the position is liquidated, and
(130 − 20) = 110 June futures contracts are sold. In early June, this position
is rolled over into a short position in 110−40 = 70 September futures. Finally,
in September, this position is rolled over into 70 − 20 = 50 Dec. futures.
A tailed hedge would initially consist of a short position in 0.951 × 20 +
0.939×40+0.919×20+0.90×50 ≈ 120 futures contracts. At the roll dates, the
new hedge will be determined by the new discount factors. Actually, between
roll dates, minor modifications to the hedge may need to be made.

ED deposits with different maturities enables the spot LIBOR curve to

be constructed at the short end. The ED futures contracts provide us with
information that will allow us to construct forward rates, and hence spot rates
for short and middle maturities. Converting the futures rates to forward rates
requires a convexity adjustment which we study in another chapter. There
are other LIBOR based products that will allow us to construct a LIBOR
zero curve for more distant maturities. These contracts are Forward Rate
Agreements and Interest Rate Swaps.

5.6 FORWARD RATE AGREEMENTS

Forward Rate Agreements, or FRAs, are forward contracts on interest rates.

Such contracts exist in most major currencies, although the market is domi-
nated by US dollar contracts. The market is primarily an interbank market,
82 CHAPTER 5: EURODOLLAR FUTURES AND FORWARDS

and the major traders communicate their quotes via electronic quotation sys-
tems.
A FRA is a cash settled contract between two parties where the payout
is linked to the future level of a designated interest rate, such as 3-month
LIBOR. The two parties agree on an interest rate to be paid on a hypothetical
“deposit” that is to be initiated at a specific future date. The buyer of an
FRA commits to pay interest on this hypothetical loan at a predetermined
fixed rate and in return receive interest at the actual rate prevailing at the
settlement date.
Let F RA0[t0, t1] represent the annualized fixed rate determined at date 0,
for the time period [t0, t1]. Let ∆t = t1 − t0 be the time period in years.
let `[t0, t1] represent the reference rate, usually LIBOR, also in annualized
form, that prevails at the settlement date, t0 . The net cash payment to the
buyer of an FRA is based on a quantity, Q(t0), given by

Q(t0) = (`[t0, t1] − F RA0[t0, t1])N ∆t

Here N is the hypothetical deposit quantity which is a predetermined fixed

constant, usually referred to as the notional principal, and ∆t represents the
“deposit” period.
Actual settlement of this payment can occur in one of two ways. In the
first form of FRA the actual cash payment of Q(t0) is made at date t1. This
contract is often preferred by corporations, but is not that common, and is
shown in Figure 5.1

Fig. 5.1 Cash Flows from A FRA

`[t0 , t1 ]∆t0

0 t0 t1

?
F RA0 [t0 , t1 ]∆t0

The more usual approach is to settle the contract at date t0 . In this case the
actual cash flow is taken to be the present value of Q(t0 ), where the reference
rate is used as the discount factor. That is, the cash payment at date t0 is

c(t0 ) = Q(t0 )/[1 + `[t0, t1]∆t

`[t0 , t1] − F RA0[t0, t1]
= × N ∆t.
1 + `[t0, t1 ]∆t
 CHAPTER 5: FORWARD RATE AGREEMENTS 83

These cash settlememt contracts are more common among banks, and are
shown in Figure 5.2

Fig. 5.2 Cash Flows from a FRA

`[t0 ,t1 ]∆t0

1+`[t0 ,t1 ]∆t0

0 t0 t1

?
F RA0 [t0 ,t1 ]∆t0
1+`[t0 ,t1 ]∆t0

Example
A bank buys a 3 × 6 FRA and read as “three by six”, with a notional of
$100m. This quote convention identifies the point in time when the contract
begins (t0 is 3 months) and ends ( t1 is 6 months). Assume the agreed FRA
rate is 4%. (F RA0[t0, t1] = 0.04) The buyer has committed to pay 4% on a
hypothetical deposit that starts in 3 months and ends in 6 months. Assume
the exact deposit period is 92 days and payment is based on “actual/360” day
basis. In this case ∆t = 92/360.
Assume three months later, three month LIBOR is at 6%. (`[t0, t1] = 0.06.)
In this case, the bank will receive
92
[0.06 − 0.04] 360
c(t0 ) = × 100m = $503, 392
1 + 0.06(92/360)

FRA Prices and LIBOR Forward Rates

At the initiation date, the buyer and seller of a FRA agree on the fixed rate
of the hypothetical deposit account. In particular, they establish F RA0[t0, t1]
such that the value of the contract at date0 is 0. The actual value of F RA0[t0, t1 ]
is given by the appropriate forward rate on the reference interest rate. In what
follows we shall assume the reference rate is LIBOR.
To establish what the fair FRA price should be, consider the following
strategy.

• Buy a discount bond that matures at date t0. At maturity roll the $1
face value into a Eurodollar deposit that matures at date t1 .
84 CHAPTER 5: EURODOLLAR FUTURES AND FORWARDS

This guarantees 1 + `[t0, t1]∆t dollars at date t1 .

• Sell a discount bond that matures at date t1. This guarantees a one
dollar obligation at date t1 , that can come from funds from the above
investment.
This leaves `[t0, t1]∆t dollars at date t1 .
• Sell a FRA with cash settlement date t0.

At t0 the payout of the FRA (with $1 Notional) is

F RA0[t0, t1] − `[t0, t1]
∆t.
1 + `[t0, t1]∆t
Assume these dollars are placed in a ED deposit with maturity t1 . The value
grows to
(F RA0[t0, t1] − `[t0 , t1])∆t

Adding these proceeds to the previous funds lead to a guaranteed cash flow
of F RA0[t0 , t1]∆t dollars at date t1. The table below summarizes the cash
flows:

Strategy Cash Flow Cash Flow

at Date 0 at Date t1
Buy 1 bond that matures at date t0 P (0, t0) 1 + `[t0, t1]∆t
and roll the proceeds into a ED account
at date t0 .
Sell 1 bond that matures at date t1 -P (0, t1) -1
Sell a FRA 0 −(`[t0 , t1] − F RA0[t0, t1])∆t
Net Cash Flows P (0, t0) − P (0, t1) F RA0[t0 , t1]∆t

The cost of this strategy at date 0 is P (0, t0) − P (0, t1) dollars. If this
amount was financed for the period [0, t1], the amount owed at date t1 would
be
P (0, t0) − P (0, t1) 1
= − 1 = f0 [t0, t1]∆t.
P (0, t1) F O0[t0, t1]
The net profit at date t1 would be

(F RA0[t0, t1] − f0[t0 , t1])∆t

and the net initial investment would be $0. Clearly, to avoid riskless arbitrage,
the final value should also equal $0. The fair FRA price is

F RA0 [t0, t1] = f0 [t0, t1]

 CHAPTER 5: EURODOLLAR FUTURES VERSUS FRAS 85

That is, the fair FRA rate is the forward rate for the period.

Example
The current three month LIBOR is `[0, t0] = 0.06, where t0 = 92 days. The
current six month LIBOR is `[0, t1] = 0.06 where t1 = 182 days. We want to
compute the fair price of a 3 × 6 based on an “actual/360 day” basis.
182−92
First, ∆t = 360 = 0.250. Now,

P (0, t0)
F RA0[t0, t1]∆t = −1
P (0, t1)

Substituting

1
P (0, t0) = = 0.98489
1 + 0.06(92/360)
1
P (0, t1) = = 0.97055
1 + 0.06(182/360)

into the above equation leads to a FRA rate of 5.910%. Notice that if the
90
date basis was “Actual/365”, then ∆t = 365 = 0.24657 years.2

FRA quotes on LIBOR are therefore precisely the same objects as for-
ward rates. Usually, the LIBOR zero curve, and hence the FRA quotes, is
established using Eurodollar futures prices and interest rate swap rate data.
Eurodollar futures are often used to hedge and price FRA contracts.

5.7 EURODOLLAR FUTURES VERSUS FRAS

Notice that a firm that buys a FRA gains from interest rate increases. In
contrast, a long position in a ED futures contract gains if interest rates decline.
Buying a FRA is almost identical to selling a ED futures contract. Of course,
since FRAs are forward contracts they are not marked to market daily as ED
futures. Banks can use ED futures to hedge exposed FRAs. Unlike exchange
traded futures, however, the FRA can be customized to closely conform to
the specific risk being hedged by the firm.

2 FRAs in British pounds use this convention. Most other currencies use “Actual/360” day
convention.
86 CHAPTER 5: EURODOLLAR FUTURES AND FORWARDS

5.8 PRICING FRAS USING ED FUTURES

In practice, due to the daily marking to market feature of futures contracts,

FRA rates will be lower than those implied by ED Futures rates. For the
moment, we will ignore the differences between futures and forwards. In this
section, we will learn how to calculate FRA strip rates from a yield curve
consisting of a spot ED deposit rate up to the first ED futures setllement date
( the cash stub rate) and the set of ED futures prices. Adjustments for the
convexity affect, and for other nuances, like the turn of the year effect will be
considered later.
To make matters specific consider the data from Table (5.3) reproduced in
the table below.

Contract Value Date Days Rate

Stub 1/15/04 60 1.16
March 04 t0 = 3/15/04 91 1.16
June 04 t1 = 6/14/04 91 1.28
Sept 04 t2 = 9/13/04 91 1.53
Dec 04 t3 = 12/13/04 91 1.89

From the table we also obtain:

1
P (0, t0) = = 0.99807
1 + 0.0116(60/360)
1
P (0, t1) = P (0, t0) × = 0.99515
1 + 0.0116(91/360)
1
P (0, t2) = P (0, t1) × = 0.99194
1 + 0.0128(91/360)
1
P (0, t3) = P (0, t2) × = 0.98812
1 + 0.0153(91/360)
Actually, to be more precise we should have convexity adjusted the futures
rates and used the resulting forward rates (and discount factors) in Table
(5.2). These values are:
P (0, t0) = 0.99807
P (0, t1) = 0.99515
P (0, t2) = 0.99195
P (0, t3) = 0.98345.

Once the discount factors are obtained then the FRA values can be iden-
tified, using the equation
P (0, ti)
F RA0[ti , ti+1]∆ti = − 1 for i = 0,1,...
P (0, ti+1)
 CHAPTER 5: CONCLUSION 87

ti+1 −ti
where ∆ti = 360 if ti and ti+1 are in days, and the basis is “actual/360”.
To determine the discount bond price for a given date that lies between
two futures dates, requires interpolating values. Assume, t1 < t < t2 . One
way of approximating P (0, t) is:
1
P (0, t) = P (0, t1) t−t1
(1 + F RA0[t1 , t2]∆t1) t2 −t1
To illustrate the idea, consider a 3 × 6 FRA starting from s0 = 3/20/04 and
expiring on s1 = 6/20/04. The number of days between s0 and s1 is 92 days
In order to establish this FRA price we need the discount factors for these
two dates.
1
P (0, s0) = 0.99807 × 5 = 0.99784
(1 + 0.01597(91/360)) 91
1
P (0, s1) = P (0, t1) × 6 = 0.994937
(1 + 0.012876(91/360)) 91
Then, substituting into the following equation,
92 P (0, s0)
F RA0[s0 , s1] = − 1,
360 P (0, s1)
leads to F RA0[s1, s2 ] = 0.011454 or 1.1454%.
Adjusting FRA Prices
The above analysis has incorporated the convexity correction that is needed
to adjust for the fact that the data came in the form of futures rates not
forward rates. A second adjustment is necessary if the FRA extends over a
calendar year. It has been observed historically, that at the year end there
is a scarcity of funds and short term interest rates often rise for the the last
business day in the calendar year to the first business day in the new year. As
trading commences in the new year, rates return to prior levels. It therefore is
common practice to make adjustments in the December interest rate futures
contract for this year end turn affect.3

5.9 CONCLUSION

In this chapter we have examined ED deposits, ED futures and the over the
counter market for FRAs. Given ED spot rates over the short end of the

3 For
details on the Year end turn effect see Burhardt and Hoskins article in Risk Magazine
1997???
88 CHAPTER 5: EURODOLLAR FUTURES AND FORWARDS

curve, the LIBOR spot rate to the expiration date of the nearest ED futures
contract, and given the prices of successive ED futures contracts, it is possible
to set up a LIBOR zero curve extending out beyoond five to seven years. In the
next chapter we shall see that interest rate swaps contain information on PAR
LIBOR rates that can be used to extract spot LIBOR rates for longer term
contracts. In a later chapter we will examine how one adjusts the implied
LIBOR ED futures rates into forward rates using a convexity adjustment.
Given the LIBOR spot curve, FRA prices can easily be established as the
appropriate forward rate.
This chapter has also illustrated the potential uses of FRAs and/or ED
futures. In particular, these contracts allows a firm to replace floating interest
rates with fixed interest rates or vice-versa. FRAs are customized contracts
that can be obtained through investment banks. These banks hedge the risk of
these products by using ED futures. In hedging the sale of a forward contract
with futures, the marking to market feature of futures has to be taken into
account. This involves tailing the hedge. Overall, very effective hedges can
be put into place. As a result, the pricing of FRAs is very competitive and
bid-ask spreads are very narrow.
 CHAPTER 5: CONCLUSION 89

Exercises

1. Mechanics of ED Futures Contracts.

A firm borrows 100 million dollars for one year, begining on September
17th. Spot three month LIBOR on that date is 5%. The firm must pay
150 basis points above LIBOR. So the initial interest rate is 6.5%. This
rate is for the first 3 months. Subsequently, the LIBOR rate will be
reset to the then current rate, with the spread staying fixed at 150 basis
points. The reset dates are December 17th of this year, March 17th
and June 17th. On September 17th, the following ED futures prices are
observed.
Delivery Month Futures Price
December 95.34
March 95.56
June 96.00
September 95.5

(a) Compute the implied ED futures LIBOR rates for each of the quar-
ters in the year.
(b) Ignoring the difference between futures and forward rates, use
the results of (a) to compute the LIBOR discount function from
September 17th to December, March, June, September and to the
following December. Assume that there are exactly 90 days in each
quarter and 360 days in the year.
(c) What ED Futures trades should be used to construct a naive hedge
that will hedge against rising LIBOR rates?
(d) Adjust the naive hedge so as to take into account the timing of
cash flows.
(e)Suppose the following spot LIBOR and Futures prices were ob-
served.
Date Spot LIBOR December March June
Futures Futures September
December 4.00% 96.00 95.00 94.82
March 4.50% - 95.50 96.60
June 4.80% - - 95.20

Compute the interest expenses each quarter for an unhedged posi-

tion. Compare these interest rate expenses to those derived from
a strip. Finally set up a naive rolling hedge using the short dated
futures contracts and compute the interest expenses assuming all
trading took place at the above dates.
90 CHAPTER 5: EURODOLLAR FUTURES AND FORWARDS

(f) How could the rolling hedge be adjusted? In particular compute

the initial number of short dated ED futures contracts that should
be traded.

2. Mechanics of FRAs
Consider a $1m 3 × 6 FRA quoted at 5.0%. A firm buys this contract.
After 3 months the spot LIBOR rate is 5.2%. Compute the profit on the
FRA assuming that there are 91 days in the final three month period.
3. Hedging FRAs with ED Futures.
Consider the problem of hedging a 100m dollar 2 × 5 FRA at 8.5%.

(a) Write down the cash flow of the FRA that occurs in 2 months time,
as a function of LIBOR rates at that time.
(b) Assume the current 2 month ( 60 day ) LIBOR spot rate is 8.1%.
Assume further that in this FRA there are 92 days between months
2 and 5. Establish the present value of a basis point change in the
FRA agreement.
(c) The value of a basis point change in the ED futures contract is
$25. Using (b) establish the number of futures contracts that are
required to hedge the purchase of the above FRA.
(d) All things being equal, what will happen to the hedge ratio over
time.

4. Computation of a Discount Function using ED Futures

The following information is given. The spot LIBOR rate for the first 23
days is 5.0%. The table below shows the expiration dates of successive
ED futures contracts and the corresponding implied ED futures 3 month
LIBOR rate.

Maturity Implied 90 day ED futures LIBOR rates

23 5.10
114 5.2
205 5.30
296 6.0
397 6.25
489 6.50

(a) Ignoring the difference between futures and forwards compute the
LIBOR discount function, unadjusted by a convexity correction.
(b) Use the discount function to establish a fair Forward rate agreement
rate for a contract that matures in 296 days, and is based on 3
month LIBOR.
 CHAPTER 5: CONCLUSION 91

5. Hedging Floating Rate Liabilities

A bank funds itself with 3 month ED time deposits at LIBOR. The

current LIBOR rate is 5.5%. The successive 3 month LIBOR rates are
unknown of course. However, the implied ED futures rates of contracts
maturing in months 3, 6 and 9 are 5.8%, 6.05%, and 6.20%. Assume
each of these three month intervals contain exactly 91 days.

The bank has a customer who wants a 100m dollar loan, with fixed
interest paid quarterly, at dates that correspond to the expiry dates of
the ED futures.

(a) Explain the risk the bank takes in providing a firm a fixed rate
loan.

(b) Explain how the bank can use ED futures to swap its floating rate
exposure into a fixed rate exposure.

(c) Ignoring the difference between forward and futures, establish the
fair fixed rate the bank could establish for its client.

(d) What hedging strategy should the firm set up at date 0. Make sure
you tail your hedge. Explain any limitations of this analysis, and
this hedge. In particular, explain the direction of bias, introduced
by not taking into account the difference between forwards and
futures.

6. Set up a FRA calculator in Excel, that has the following structure:

92 CHAPTER 5: EURODOLLAR FUTURES AND FORWARDS

Inputs:

Settlement Date
Underlying Maturity Date

Spot Rate to FRA Expiration Date (%)

Interest Rate Frequency (1 (annual) , 2 (semi-annual), or 4 (quarterly) )

Spot Rate to Final Maturity Date (%)

Interest Rate Frequency (1,2, or 4)

Intermediate Calculations:

Days to Expiration Date

Days to Underlying Maturity Date
Days Between Maturity Date and Expiration Date
Continuous Rate to Expiration (%)
Continuous Rate to Maturity (%)

Output:

Forward Rates (%):

-Continuous Compounding
-Quarterly Compounding
-Semiannual Compounding
-Annual Compounding

In the spreadsheet, the interest rate frequency refers to the compounding

interval and is 4 if quarterly, 2 if semiannual, and 1 if annual.

7. FRAs and the Cost of Carry Model.

LIBOR rates are shown below:
Maturity Rate
7 days 2.00
14 days 2.20
30 days 2.30
60 days 2.50
120 days 3.00

(a) Use these LIBOR rates to construct the price of LIBOR bonds with
maturities 7, 14, 30 and 60 days.
(b) Establish the theoretical ED futures price for a 90 day ED futures
contract that expires in 30 days time. Ignore the difference between
futures and forwards.
 CHAPTER 5: CONCLUSION 93

(c) If the actual price of the ED futures was higher than the theoetical
price by 30 basis points, how could you set up an arbitrage free
position. What assumptions have you made?
(d) Establish the fair FRA value for a contract that starts in 7 days
and ends in 90 days. What assumptions have you made.