Eurodollar

Eurodollars are deposits denominated in United States dollars at banks outside the United States, and thus are not under the jurisdiction of the Federal Reserve. Consequently, such deposits are subject to much less regulation than similar deposits within the United States, allowing for higher margins. There is nothing "European" about Eurodollar deposits; a US dollar-denominated deposit in Tokyo or Caracas would likewise be deemed Eurodollar deposits. Neither is there any connection with the euro currency.

More generally, the "euro" prefix can be used to indicate any currency held in a country where it is not the official currency: for example, euroyen or even euroeuro.^[1]

History

Gradually, after the Second World War, the amount of U.S. dollars outside the United States increased enormously, both as a result of the Marshall Plan and as a result of imports into the U.S., which had become the largest consumer market after World War II.

As a result, enormous sums of U.S. dollars were in custody of foreign banks outside the United States. Some foreign countries, including the Soviet Union, also had deposits in U.S. dollars in American banks, granted by certificates.

During the Cold War period, especially after the invasion of Hungary in 1956, the Soviet Union feared that its deposits in North American banks would be frozen as a retaliation. It decided to move some of its holdings to the Moscow Narodny Bank, a Soviet-owned bank with a British charter. The British bank would then deposit that money in the US banks. There would be no chance of confiscating that money, because it belonged to the British bank and not directly to the Soviets. On February 28, 1957, the sum of $800,000 was transferred, creating the first eurodollars. Initially dubbed "Eurbank dollars" after the bank's telex address, they eventually became known as "eurodollars"^[2] as such deposits were at first held mostly by European banks and financial institutions.^[2]

Gradually, as a result of the successive commercial deficits of the United States, the eurodollar market expanded worldwide.

Eurodollar Futures Contract

The Eurodollar futures contract refers to the financial futures contract based upon these deposits, traded at the Chicago Mercantile Exchange (CME) in Chicago. Each CME Eurodollar futures contract has a notional or "face value" of $1,000,000, though the leverage used in futures allows one contract to be traded with a margin of just hundreds of dollars. Trading in Eurodollar futures is extensive, thus offering uniquely deep liquidity. Prices are quite responsive to Fed policy, inflation, and other economic indicators.

CME Eurodollar futures prices are determined by the market’s forecast for the delivery month of the 3-month USD LIBOR interest rate. The futures prices are derived by subtracting that implied interest rate (yield) from 100.00. For instance, an anticipated interest rate of 5.00 percent will translate to a futures price of 95.00 (100.00 – 5.00 = 95.00). However, the price in practice, the settlement price, is higher than the quoted price to reflect a lower return for 3 months instead of one year. This 95 dollar future, is actually traded at 98.75 (100-5.00/4). And one future contract is traded at $987,500. On the expiry day of a contract, the contract is valued using the current fixing of 3-month LIBOR.

How the Eurodollar futures contract works

For example: If you are a buyer of a single single 95.00 quoted contract(anticipated future interest rate is 5%), if

at expiration - the interest rate has risen to 6.00%

  contract will be quoted at 94.00
     the buyer compensates the seller 25¢ on each $100 in the $1,000,000 valued contract.
     You pay $2,500.

at expiration - the interest rate has fallen to 4.00%

  contract will be quoted at 96.00
     the seller compensates the buyer 25¢ on each $100 in the $1,000,000 valued contract.
     You receive $2,500.

The buyer of one Eurodollar future contract agrees to buy 1 million dollar for the price determined now (the price in practice) 3 months prior to get back the 1 million. In other words, the buyer agrees to be the lender in the future with a predesignated discount rate today. At expiration, usually the buyer chooses not to deliver the loan, and instead accept a differential cash flow - either positive or negative- to compensate the seller for selling/borrowing it on the spot market. For example, the 95 dollar contract at expiration comes to $94, settlement price $98.5, the buyer compensates the seller 25c per $100, $2,500 per contract so that the seller can now sell/borrow 100 dollar in 3 months at market price/market availabe loan $98.50/$100 with 25c/$100 at hand as if selling/borrowing it at the predesignated $98.75. On the other hand, the buyer can now buy $100 in 3 months at the market but still pays $98.75/$100=$98.50/$100+$.25/$100. If Eurodollar rises to $96, the opposite cash flow with occur to transfer current market price to predetermined price. In both cases, one percent interest rate change brings both parties $2,500 either win or loss per contract. Hence .01 percent (called 1 basis point) intereste rate change generates $25 win or loss per contract. As we often see in economic news, interest rate always comes in two decimal percentages like 3.75% or 3.50%. And the size of one Eurodollar contract ensures settlement in an integer of dollars.

As with other fixed rate instruments, if the yield rises, the price of the futures contract falls, and vice versa. If you believe that interest rates will fall, you would then buy a CME Eurodollar futures contract because you expect the contract price to rise (and vice versa; if you believe rates will rise, you would sell or short-sell a CME Eurodollar futures contract because you expect the contract price to fall). This retains the normal inverse relationship between the price and the yield of interest rate securities. However, the bond convexity is not maintained due to the pricing of the Eurodollar contracts in yield terms.

40 quarterly expirations and 4 serial expirations are listed in the Eurodollar contract. ^[3] This means that on January 1, 2008, the exchange will list 40 quarterly expirations (March, June, September, December for 2008 through 2017), the exchange will also list another four serial (monthly) expirations (January, February, April, May 2008). This extends tradable contracts over ten years, which provides an excellent picture of the shape of the yield curve. The front month contracts are among the most liquid futures contracts in the world, with liquidity decreasing for the further out contracts. Total open interest for all contracts is typically over 10 million.

The CME Eurodollar futures contract is used to hedge interest rate swaps. There is an arbitrage relationship between the interest rate swap market, the Forward Rate Agreement market and the Eurodollar contract. CME Eurodollar futures can be traded by implementing a spread strategy among multiple contracts to take advantage of movements in the forward curve for future pricing of interest rates.

Eurodollar contracts are extremely popular due to their ability to accurately hedge the mortgage market debt. The correlation with mortgage market debt is extremely high, higher than the CBOTs Treasury Futures contracts.

In the past, the minimum price fluctuation of a Eurodollar futures price was 0.01 (for example, a price change from 96.44 to 96.45). A price change of 0.01 is referred to as a "tick" and represents a change in yield of a basis point. The exchange has reduced over time the minimum price fluctuation of the contract because of increasing liquidity. As of December 2007, these are 0.0025 (a quarter tick) for the nearest expiring month and 0.005 (a half tick) for all other months.^[3] This notation is confusing because strictly one tick is defined as the minimum price fluctuation of a futures contract.

A tick in CME Eurodollar futures is worth $25.00, based on the $1,000,000 notional value of this contract, as calculated below:

$1,000,000 notional value x .0001 (one basis point) x 90/360 (three month) deposit period = $25.00.

Eurodollar sweeps

In United States Banking, eurodollars are a popular option for what are known as "sweeps". By law, banks aren't allowed to pay interest on corporate checking accounts. To accommodate larger businesses, banks may automatically transfer, or sweep, funds from a corporation's checking account into an overnight investment option to effectively earn interest on those funds. Banks usually allow these funds to be swept either into money market mutual funds, or alternately they may be used for bank funding by transferring to an offshore branch of a bank (thus a eurodollar).