ok, both the eurodollar forward and future has as underlying a future eurodollar spot rate for a specific term (say 60 days) and covers a notional amount, now 1. the payoff for the eurodollar forward is the difference in would-be interest payments on the rate specified in the contract and the actual spot rate at expiration, such that if you’re the long, you would GAIN if the spot rate is above the contract rate at expiration 2. now eurodollar future are priced using discount interest (100-rate IMM index), so igains/losses are as follows, if you’re long the contract, you would LOSE if there’s an upward movement in the expected future spot rate Now, mechanically, this is pretty easy to understand (assuming I didn’t misread anything from the book), but what’s bugging me is the fact that an upward movement in the eurodollar rate would generate opposite results for the forward and the future contracts. Did I miss something here? Also, the fact that a long in a future contract profits from a downward movement in the rate seems awfully odd to me, since the long in a future contract, like the forward contract, is buying the underlying, in this case the future eurodollar spot rate, at the contract price, so you’d expect to profit from such a long position if the underlying appreciates, rather than depreciates…maybe I’m really missing something here…the only explanation I can come up with is because this convention was borrowed from T-bills futures and the “rate” in T-bills is really the yield and since yield and price have inverse relationship, hence the result, but somehow, this doesn’t sound convincing to me…
It wasn’t borrowed from T-Bill futures; it was blatantly ripped off causing volume in T-Bill futures to drop to near 0 while ED futures became one of the most liquid securities in the world. Anyway, this convention doesn’t just apply to Eurodollar futures but all (at least all I can think of) interest rate futures globally - LIBOR, Fed Funds, EURIBOR, etc… A forward contract can be anything anybody wants it to be. I’m not sure why anybody would trade a forward contract with payoff like the futures contract instead of a Forward rate agreement (FRA). Is that what you are talking about when you say forward contract?
ya, I was referring to a FRA when I said forward contract. but unlike all the other forward/future pairs/counterparts where they have similar payoffs, for interest rates it’s different, why or how did the difference in payoffs between the FRA and the future contract come about?
You’ll get this in level III, I believe. A ED futures contract has no convexity ($25/tick no matter what the rate). An FRA does have convexity because of the in arrears treatment. When the invented the ED contract, they wanted to make it really simple so people would trade it and the plan worked. Alas, if you are hedging risk that is convex with ED futures (like LIBOR linked debt) you might have a little problem.