One of the key reasons the Eurodollar contract has become so liquid and successful is because of hedgers using the market to hedge against adverse interest rate fluctuations.
Because Eurodollar futures move inversely with interest rates, if you are concerned about rising rates, you can sell Eurodollar futures and if you are concerned about declining rates, you might buy Eurodollar futures.
Many loans are structured such that the rate floats periodically (i.e. the interest rate is reset quarterly) as a function of LIBOR plus a fixed premium. This introduces a periodic risk that rates may fluctuate before the time of each periodic loan reset date. Eurodollar futures may be used to address this possibility to the extent that they are listed on a quarterly basis extending 10 years out into the future.
Eurodollar Strip Example
There exist various strategies for hedging with Eurodollars involve stacking and stripping futures contracts as well as products called packs and bundles, which are packaged strips.
Assume that it is March 2017 and a corporation assumes a two-year bank loan repayable in March 2019 for $100 million. The loan rate is reset every three months at LIBOR plus a fixed premium. As such, the loan may be deconstructed into a series, or strip, of eight successively deferred three-month periods. Note: If the loan is secured currently, the effective rate may be fixed at the current rate for the first three months. Thus, there is no risk over the first three-month period between March and June 2017. However, the corporation remains exposed to the risk that rates advance by each of the seven subsequent loan rate reset dates.
Considering that the floating rate loan may be decomposed into seven successively deferred 90-day loans. The BPV associated with each of those seven loans equals $2,500.
BPV = $100,000,000 x (90÷360) x 0.01% = $2,500
The corporation might sell 100 Eurodollar futures in successive quarterly contract months to match the seven successive quarterly loan reset dates. Therefore, one might effectively hedge each of the seven loan periods independently. This transaction is often referred to as a strip hedge, or a series of short (or long) Eurodollar futures in successively deferred contract months to hedge the risk of rising (or declining) rates, respectively.
|Reset Date||Action to Hedge Rate Reset|
|June 2017||Sell 100 Jun-17 futures|
|September 2017||Sell 100 Sep-17 futures|
|December 2017||Sell 100 Dec-17 futures|
|March 2018||Sell 100 Mar-18 futures|
|June 2018||Sell 100 Jun-18 futures|
|September 2018||Sell 100 Sep-18 futures|
|December 2018||Sell 100 Dec-18 futures|
If rates climb higher over the term of the loan, the short Eurodollar futures contracts would be profitable as the futures decline as rates rise. The profit on the strip of Eurodollar futures would offset the increase borrowing costs effectively locking in a lower rate.
Corporate treasurers and bank asset liability mangers are particularly aware of fluctuations in interest rates as borrowing and lending rates directly influence profitability. They have many tools available to hedge their interest rate exposure and on the Eurodollar or LIBOR side of the business, there is no better instrument.
Indeed, the hedging community has embraced strip hedging so enthusiastically that CME Group has launched a variety of pre-packaged strips that are called packs and bundles.
Peter Knight Advisor