I have struggled with understanding the concept that makes it difficult to use Eurodollar futures in a riskless arbitrage or as a perfect hedging instrrument, in constrast with T-bill futures. These two share very similar attributes, what’s so bad about Eurodollars futures that makes it less appealing?
I am hoping some kind soul could help with some simplistic intution on this.
ok, here’s my stab at this.
the eurodollar futures (EDF) are meant to represent you loaning money. So you buy an EDF, it means you are locking in a rate to lend money at a set rate for 30 days some time starting in the future (say 3 months from now). At least that’s what the contract is meant to represent.
so if rates are 5%, the interest you are going to earn at the end of that 30 day loan is going to be $1M * 5% * 30/360. If you buy this contract and rates go up by 0.01%, you lose $25. That’s the way the contract works.
The thing is, if you actually loaned someone money for that 30 days, yeah you would make that $1M * 5% * 30/360, but that interest is paid at the end of the 30 days. There is NO discounting effect calculated like there is when you do a FRA.
So EDFs don’t actually reflect the economic reality of what you would gain/lose when you loan/borrow money and rates move. This is why they are not a perfect hedge.
To your question, why does it work for t-bills and not EDFs. The EDFs don’t discount back the interest cash flow to your futures expiry point, whereas the T-bills futures do (a future on a discount security)
I’m no expert but this is how I understand it.
Thanks Clever one. I understand the explanation you’ve given perfectly well. But I’m still a bit short on its application to hedging.
I saw a question on a scheweser mock somewhere asking which would be a better way to hedge a long exposure to a floating rate bond in the case of declining interest rates. The options provided included a long Eurodollar futures, a short Eurodollar futures and a Long Treasury futures.
The answer is to take a long position in Eurodollar contracts
The explanation is
The Eurodollar contract is a more effective way to hedge Libor Based investment because the Eurodollar contract is a Libor contract. The t-bill contract is based on T-bill rates which are not perfectly correlated with Libor rates, so hedging a Libor investment with a T-bills futures will result in a less effective hedge. Reichman should take a long position in Eurodollar contract, if interest rates decrease, his yield on the Libor based security will fall but the decrease will be offset by gains in a long position on the Eurodollar futures contract.
This left me very confused for a number of reasons
First, my understanding is that a floating rate instrument should have very limited interest rate risks, i just can’t seem to wrap my mind around the idea of hedging the sensitivity to interest rates.
Second, my understanding is that Eurodollar futures should not be used as hedging instruments and you have just made a sensible argument for this. But how do i reconcile that with the answer given to this question?
This is a really though concept…
I have problems with it myself. Doubt whether there are many candidates here that could explain it in plain language. The CFAI text alone only mentions it.
This helped me understand why they use a long eurodollar future to hedge against decreasing intrest rates.
http://www.youtube.com/watch?v=28yDWeEBbPM
Basically as the contract is quoted on a discount rate (100 - LIBOR) as LIBOR increases the quote decreases and you lose money, as LIBOR decreases you are closer to 100 and are gaining money. As previously mentioned it is like you are locking in the rate you initiate the contract at.
Also not sure that the euro dollar future is considered generally bad as a hedge, just that it shouldn’t be used to hedge t-bill exposure as a not a prefect match. It also might be due to the large notional size of each contract meaning that it is difficult to get a perfect hedge.
Hey Bloodline,
it is NOT my understanding that EDFs should not be used to hedge. If you have exposure to LIBOR, then they are very well suited and definitely better that T-bill futures (which are highly correlated to LIBOR but NOT Libor based).
The main takeaway from that LOS IMO is just to understand that T-bills and T-Bill futures are contracts that allow to enter into riskless arbitrage, whereas this is not the case when you compare eurodollar deposit vs. eurodollar futures. It’s not saying that EDF is not a valid hedging instrument, just that it doesn’t quite work in the way you’d expect it if you’re used to trading t-bill futures.