Eurodollar Accounts

The term Eurodollar applies to any account based in U.S. dollars that is held at a financial institution outside the United States. Despite the “euro” prefix, the account need not be held in Europe – any jurisdiction outside the U.S. makes it a Eurodollar account.

The Eurodollar moniker came about during the aftermath of the Second World War when the U.S. provided funds to help the countries devastated during the war. As part of the rebuilding strategy, the U.S. also increased imports from many European countries and paid with U.S. dollars as in many cases, the local currencies were worthless. Together, these two events ensured that large sums of U.S. dollars were held in European financial institutions and these accounts became known as Eurodollar accounts.

Because Eurodollar accounts are held outside the United States, they do not fall under the jurisdiction of the Federal Reserve and are not subject to the same regulations as U.S. depository institutions. In some cases, this enables banks dealing in the Eurodollar market to operate on tighter margins than their U.S. counterparts.

Eurodollar Futures Contracts

The CME Group - the new trade exchange resulting from the recently combined Chicago Mercantile Exchange and Chicago Board of Trade exchanges – provides an exclusive market for the trading of Eurodollar future contracts. Each Eurodollar contract has a notional (i.e. face) value of $1 million and the contract itself represents the interest earned on $1 million for a three-month period. According to the CME website, the Eurodollar futures contract is the most widely-traded futures product in the world thus ensuring a very deep market and high degree of liquidity for the Eurodollar futures secondary market.

The yield for the Eurodollar contract is determined by the 3-Month LIBOR rate that corresponds with the expiration date of the contract. The premium for the contract is determined by subtracting the yield (that is, the stated interest rate for the $1 million) from 100.00.

For instance, if the contract has a stated interest rate of 3%, then the premium for the futures contract will be 100.00 – 3.00 = 97.00. This means it will cost $97.00 to purchase a single Eurodollar futures contract with a 3% implied yield. On the day the contract expires, the contract value is “fixed” using the current LIBOR overnight rate for Eurodollars. This results in an arbitrage opportunity between the price at which the contract was issued, and the price calculated at expiry, with the difference between the two representing either a gain or a loss for the investor.

Because the yield price at which you buy a Eurodollar futures contract is pre-determined, it is considered a fixed income investment. Therefore, as a fixed income security, it maintains an inverse relationship with interest rates and it is your projected change in interest rates for the three months of the contract that determines if you will be a futures contract buyer or a seller.

The relationship between fixed income yields and interest rates dictates that as interest rates rise, the price of existing contracts falls. This is because the yield (that is the “fixed” part of the contract) is a less attractive investment option when compared to new contracts that have higher yields to compete with the higher interest rates. The price of existing futures contracts falls because investors (buyers) can lock in more favorable returns by buying the more recently-issued futures contracts with the better yields.

When existing Eurodollar futures contracts are traded, the price of the contact will fluctuate in response to changes in the LIBOR rate. Price changes are expressed in “ticks”, with one tick being 0.01. If the original price was 97.00, then a drop of one tick would adjust the price to 96.99 – an increase in the price from 97.00 to 07.02 would be an increase of two ticks.

Keeping this inverse relationship between price and interest rate in mind, if you predict a rise in interest rates, then your approach should be to short (i.e. sell) Eurodollar futures. This enables you to receive payment now but you will be forced to deliver the price of the contract at expiry time. However, if your strategy is successful, you will have profited on the transaction as you will have received more than you are required to pay at the end of the contract. Conversely, if you feel that interest rates will fall, then you should go long (i.e. buy) Eurodollar futures now as the price will experience a positive gain during maturity period the contract.

Who Deals in Eurodollar Futures?

There are two primary groups that make use of Eurodollar futures. Speculators – those that seek to profit on an expectation of future conditions – are looking for investment opportunities that provide a means of making a profit. The example above is an illustration of how Eurodollar futures can be used to speculate on changes in the 3-Month LIBOR interest rate.

In addition to speculators, there is also a great demand to use these contracts as a way to hedge market derivatives products such as interest rate swaps. An interest rate swap is an agreement whereby two parties agree to swap (exchange) interest rate payment streams on an agreed-upon amount of principal.

This occurs when one party with funds invested in various investment vehicles with fluctuating returns enters into an agreement with a second party that provides a pre-determined schedule of fixed payments to the owner of the funds. In consideration for providing these payments, the second party receives any income generated by the principal. If the market returns exceed the fixed payments, the second party stands to realize a profit – if the market returns fail to exceed the fixed payments, then they suffer a loss.

Clearly, the greatest risk to the second party’s success lies with changes to the interest rate. Entering into Eurodollar futures contracts is one way to mitigate the risk of interest rates moving against you. For example, if you have a swap agreement that could trigger losses if interest rates rise, then the position can be hedged by shorting a sufficient quantity of Eurodollar futures to off-set the potential losses.