Interest Rate Predictions And How To Check Them Using The Eurodollar Contract

Interest Rate Predictions

Interest rates are crucial to the financial market and an asset in economic policy. They affect us directly and have a great impact on living standards. Increasing interest rates make it difficult to pay mortgages and borrow money.

Interest rates depend on several factors and fluctuate constantly. This makes predicting interest rates very difficult. Forecasting interest rates helps regulatory bodies to adapt to these changes and act accordingly.

What Is A Eurodollar?

Eurodollars are US dollars deposited or held in banks outside the United States. The term “Eurodollar” came to be as these were initially held in European banks. However, eurodollars today are held worldwide in various banks.

As these time deposits are made outside the US borders, they are not subjected to the jurisdiction of the Federal Reserve. They offer higher yields and pose a higher level of risk as they are not subjected to US bank regulations.

Eurodollar Futures

In 1981, the Chicago Mercantile Exchange (CME) launched the first-ever Eurodollar futures contract. This was a cash-settled and interest-rate-based financial futures contract based on the Eurodollar.

Eurodollar futures are time deposits with a principal value of $1 million and a maturity period of three months. They were initially traded at CME with the symbol ED. However, today most trading takes place electronically with the symbol GE.

The Eurodollar Futures electronic market is open from Sunday through Friday, 6 p.m. to 5 p.m. EST, on the CME Globex electronic trading program.

They are quarterly contracts with expiries in March, June, September, and December. The tick size (minimum fluctuation) in the nearest expiring contract month is one-quarter of a basis point (0.0025 = $6.25 per contract) and one-half of a basis point (0.005 = $12.50 per contract) in all other contract months.

LIBOR And Eurodollars

The eurodollar futures rate reflects the interest rates offered on the U.S. dollar deposits held in foreign banks. More specifically, it represents a market estimate of the 3-month US dollar London Interbank Offered Rate (LIBOR) interest rate expected on the contract’s settlement date.

The contracts are traded using a price index, a numerical obtained by subtracting the LIBOR interest from 100. So, an interest rate of 5% would give you a price index of 95.00. So if the interest rate increases, the eurodollar futures will decrease and vice versa.

So, for example, with a tick size of 0.0025, if you buy a contract at $96.00 (implying LIBOR 4%), and the rate increases to $96.04 (implying a fall in LIBOR by 0.04), the buyer would have profited a $100 (0.01 equals to $25 per contract, so a 4-point increase will equal $100).

Eurodollar Contracts To Predict Interest Rates

The dollar has become the most important global currency dominating global trade and finance. Consequently, eurodollars have gained high popularity and play a major role in international markets, making eurodollar futures the fundamental building block of the financial market. They are a benchmark and preferred tool of investors to predict interest rates.

Hedging with Eurodollar Futures

One of the main reasons the Eurodollar contract has grown so liquid and profitable is that hedgers are using the market to hedge against adverse interest rate swings. Eurodollar contracts have an inverse relationship with interest rates.

You can liquify your assets if you fear a rise in interest rate, and you can buy more Eurodollar futures if the declining rates are a cause of concern.

For example, if a company is aware that it may have to take a $4m loan in June, it can hedge the interest rate by short-selling four contracts in March. So if the interest rates increase by June, the company would make a profit as the Eurodollar futures prices will drop.

Similarly, if a company takes a two-year bank loan for $100m, the company will have to pay a fixed premium plus the loan rate (which will be different for every quarter, as LIBOR is reset every three months).

In this case, the company can buy 100 contracts and deconstruct them into a series of 8 strips. The company can then sell them in successive contract months to match the quarterly loan reset dates and hedge the loan periods independently.

In both cases, the company will be able to offset the rise in interest rates. As the rate climbs higher, the company makes a profit by selling the contract. In this way, it will effectively hedge interest rate fluctuations.

Speculating With Eurodollar Futures

As Eurodollar futures is an interest rate product, the policy decisions of the U.S Federal Reserve largely affect Eurodollar futures. So any announcements and economic releases that influence Federal reserve monetary policy result in volatility in the eurodollar market.

Major changes in Federal Reserve policy in terms of increasing or decreasing interest rates occur over several years. These trends in monetary policy impact eurodollar futures. Some speculators rely on these long-term trending characteristics of the eurodollar and use trend-following strategies to make a profit.

The high liquidity and low intraday volatility of eurodollar futures offer small and large traders several opportunities.