Eurodollar Futures vs. FRAs
- Eurodollar Futures
- - Exchange Traded
- - Standardized terms
- - Buying a Eurodollar future (depositing) gives protection from falling rates
- - Counterparty is the clearing house
- - Marked to market daily
- Forward Rate Agreements (FRA)
- - Private Agreements
- - Customized terms
- - Buying an FRA (borrowing) gives protection from rising rates
- - Gives rise to counterparty risk
- - Usually no intermediate cash flows; give favorable tax/accounting treatment .
Eurodollar Futures Contract
- - A Euro$ futures contract can be thought as an agreement to deliver a future three-month time deposit on US$1-million in exchange for a price established at the time the contract is traded.
- - The contract deposit begins two days after the contract expiration date.
- - Rate of return is determined by subtracting its market price by 100.
- - For example, if you buy March 2000 contract at 94.93, you will be entitled to a three-month dollar deposit in March 2000 with a rate of 5.07%.
- - In practice, no physical delivery would take place.
- - The contract will settle in cash at the close of each trading day.
- You would receive your gains if rates fall, or
- - You would pay your losses if rates rise.
Eurodollar Futures Strip
- - Euro$ futures contracts represent future deposit periods.
- - They can be used to lock-in short-term rates (LIBORs ) for forward three-month periods.
- - By stringing together a series of contracts expiring at sequential three-month intervals, information for longer period can be obtained.
- - Such a series is referred to as a Euro$ strip
Forward Rate Agreements (FRA)
- - Many people consider FRAs “OTC Euro$ contracts.” This is partly true.
- - An FRA buyer locks in a forward borrowing rate (generally for one period) on a stated nominal amount. Terms often correspond to Euro$ futures terms
(indexed to LIBOR, $1million contract size, same settlement date) but don’t have to. - - Generally quoted as “x by y,” where x tells us when the rate becomes effective (settlement date) and y tells us when the obligation ends. For example:
(ex) 3x6 FRA (begins in 3 months, ends in 6 months -- covers a 3 month period)
1x7 FRA (begins in 1 month, ends in 7 months -- covers a 6 month period)
FRA
- - FRAs are generally settled for cash in advance (at the beginning of the contract period), but the settlement amount is valued at the present.
- - If entered into a $1million, 3x6 FRA at 5.55%, and actual LIBOR in 3-months (the settlement date) is 5.62%, the transaction would look like:
- - The right to borrow was bought at 5.55%, versus 5.62% of the actually prevailing. (One must actually borrow at 5.62% but, be compensated by the FRA)
- - Should receive the present value of the difference (7 basis points) on $1million for a 91-day period. FRAs use actual/360 day count.
- - [.0007 x 1,000,000 x (91/360)]/(1+(.0562 x 91/360)) = $174.46
· Change the Order - What would one pay/receive if the rate on the settlement date was 5.52%?
(0.0003 x 1,000,000 x 91/360)/ (1+(0.552 x 91/360)) = $66.54 The amount of $66.54 should be paid.
·Therefore buying the contract regardless of the interest rate level at the time of the borrowing, has an effect of confirming the floating interest rate of 5.55%
