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. [ [http://www.riskglossary.com/link/eurodollar_deposit.htm Eurodollar Deposit] is an overview article]

History

Gradually, after the Second World War, the quantity of U.S. dollars outside the United States increased enormously, as a result of both the Marshall Plan and 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 the 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""Adam Smith", "Paper Money", London: Macdonald & Co, 1982, p. 122] as such deposits were at first held mostly by European banks and financial institutions.

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 about one thousand 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 date of the 3-month USD LIBOR interest rate. The futures prices are derived by subtracting that implied annualized interest rate from 100.00. For instance, an anticipated annualized interest rate of 5.00 percent will translate to a futures price of 95.00. 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 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 on the delivery date to lend 1 million dollars for three months at the annualized interest rate determined now (implied by the trade price). The seller agrees to accept the loan. However, the contracts are settled in cash and no actual transfer $1,000,000 occurs. The difference between the purchase price and the final settlement price is eqivalent to the deficit or excess interest (in cash terms) that would have been paid on the nominal $1,000,000 deposit at the end of the deposit which nominally starts on the delivery date. (i.e. If you buy a contract and the rate increases you lose money because you are making less money than you would have if you agreed the rate on the delivery date.) This interest is calculated as simple interest on a 30/360 basis for three months. So if S is the final settlement price, the interest payment would be: (100-S)/100 x 90/360 x $1,000,000. Thus a change of one price point, or 1% in annualized rate, is equivalent to 1/100 x 1/4 x $1,000,000 = $2,500. Thus the appropriate hedging position can be used to deliver a cash flow that compensates the hedger for the change in interest rates that occurs between the trade date and the settlement date. However, since futures contracts are marked-to-market daily by the clearing house of the exchange these transfers actually occur incrementally through the period between the trade date and the delivery date and not just on the delivery date. The minimum price fluctuation at the CME is 0.005 points (half a basis point) on all delivery months except when a contract is due to deliver within a month, in which case it is 0.0025 points (a quarter of a basis point). These are equivalent to $12.50 and $6.25 per contract respectively.

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. [http://www.cme.com/clearing/clr/spec/contract_specifications_cl.html?product=ED CME Eurodollar Contract Specifications. Accessed 09 December 2007.] ] 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 tradeable 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 LIBOR swaps and other market instruments such as mortgage market debt. The correlation with mortgage market debt is extremely high, higher than the CBOTs Treasury Futures contracts.

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

See also

*Swaps
*Forward Rate Agreement
*LIBOR
*TED spread
*Eurocurrency
*Petroeuro
*Eurozone
*Currencies related to the euro
* The eurodollar is also a fictional currency used worldwide in the setting of Cyberpunk 2020

References

Bibliography

* Boberski, David Valuing Fixed Income Futures. 1st edition, 2006
* Ratti, B. Comércio Internacional e Câmbio. 9ª Edição. São Paulo, Brazil, Edições Aduaneiras, 1997
* Sandroni, P. Novíssimo Dicionário de Economia. 5ª Edição. São Paulo, Editora Best Seller, 2000.

External links

* [http://www.bba.org.uk the British Bankers Association] compiles Libor rates earned on Eurodollars.
* [http://www.cme.com/trading/prd/ir/eurodollar_FA.html CME website] on Eurodollar futures contract.