An Introduction to Trading Eurodollar Futures

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An Introduction to Trading Eurodollar Futures

Eurodollars, which are often mistaken with the EUR/USD currency pair or euro FX futures, have nothing to do with Europe’s unified currency, which was introduced in 1999. Eurodollars, on the other hand, are time deposits denominated in US dollars and kept in banks outside of the US. A time deposit is essentially an interest-bearing bank deposit with a set maturity date.

Eurodollars are not subject to the Federal Reserve’s authority and are subject to a lesser degree of regulation since they are not held inside US boundaries. Furthermore, since eurodollars are not subject to US banking rules, investors face a greater degree of risk, which is reflected in higher interest rates.

Key Takeaways

  • Eurodollars are a sort of US dollar deposit maintained in a bank outside of the US. They are not to be confused with the euro/US dollar (EUR/USD) currency combination or the euro currency.
  • The word eurodollars comes from the fact that it originally referred to dollar-denominated deposits kept mostly in European banks, although dollar deposits are now held in a number of institutions throughout the world.
  • Eurodollars often provide higher rates since they are not regulated by US banks and so pose more risk.
  • Eurodollar futures are traded on the Chicago Mercantile Exchange both on the trading floor and online.

The eurodollar got its name from the fact that the first dollar-denominated deposits were mostly kept in European banks. Initially, these deposits were referred to as eurobank dollars. However, deposits denominated in US dollars are now stored in financial hubs across the world and are still referred to as eurodollars.

Similarly (and similarly perplexingly), the word eurocurrency refers to currency deposited in a bank that is not situated in the nation where the currency was issued. For example, Japanese yen deposited in a Brazilian bank would be considered eurocurrency.

History of Eurodollars

Following the end of World War II, the amount of US dollar deposits held outside of the US increased significantly. Higher levels of imports into the United States and economic help to Europe as a consequence of the Marshall Plan were also causes.

The eurodollar market dates back to the 1950s, when the Soviet Union began to shift its dollar-denominated earnings (earned from selling commodities such as crude oil) out of US institutions. This was done to avoid the United States from freezing its assets. Since then, eurodollars have grown to be one of the world’s major short-term money markets, with their interest rates serving as a benchmark for corporate finance.

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Eurodollars are also employed in the TED spread, which is a credit risk indicator. The TED spread is the price differential between three-month US Treasury futures contracts and three-month eurodollar futures contracts with the identical expiry months. T-Bill and ED, the symbol representing the eurodollar futures contract, are combined to form TED. The TED spread’s growth or reduction indicates opinion about the default risk level of interbank loans.

Eurodollar Futures

In 1981, the Chicago Mercantile Exchange (CME) introduced the eurodollar futures contract, which was the first cash-settled futures contract. The underlying product in eurodollar futures is a $1 million eurodollar time deposit with a three-month maturity. When cash-settled futures contracts expire, the seller may transfer the corresponding cash position rather than delivering the underlying asset. (However, to prevent delivery, most traders settle futures contracts before to expiry with an offsetting transaction.)

Eurodollar futures were first traded on the top floor of the Chicago Mercantile Exchange in its biggest pit, which could hold up to 1,500 dealers and clerks. The vast bulk of eurodollar futures trading is now done online.

Trading eurodollar futures contracts requires opening an account with a brokerage company that specializes in futures trading, as well as making an initial margin deposit.

The open outcry eurodollar contract symbol is ED, while the electronic contract symbol is GE. Eurodollar futures are traded electronically on the CME Globex electronic trading platform from 6 p.m. to 5 p.m. EST Sunday through Friday.

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

Eurodollars have proven to be one of the most popular CME contracts in terms of average daily volume and open interest (the total number of open contracts).In terms of average daily trading volume and open interest, the futures often outperform the E-Mini S&P 500 futures (an electronically traded futures contract that is 50 times the value of the S&P 500), crude oil futures, and 10-Year Treasury Note futures.

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LIBOR and Eurodollars

The price of eurodollar futures represents the interest rate provided on US dollar deposits maintained in banks located outside of the US. More precisely, the price represents the market estimate of the 3-month US dollar London Interbank Offered Rate (LIBOR) interest rate expected on the contract’s settlement date.

LIBOR is a short-term interest rate benchmark at which banks may borrow cash in the London interbank market. Eurodollar futures are a LIBOR-based derivative that represent the London Interbank Offered Rate for a $1 million offshore deposit held for three months.

Eurodollar futures prices are calculated by subtracting 100 from the estimated 3-month US dollar LIBOR interest rate. A eurodollar futures price of $96.00, for example, implies an expected settlement interest rate of 4%, or 100 minus 96. Price goes in the opposite direction of yield.

For example, if an investor purchases one eurodollar futures contract at $96.00 and the price climbs to $96.02, the implied settlement of LIBOR falls to 3.98%. The futures contract buyer will have earned $50. If one basis point, or 0.01, is $25 per contract, then a shift of 0.02 equals a $50 per contract change.

Hedging with Eurodollar Futures

Eurodollar futures are an efficient way for businesses and banks to lock in an interest rate on money they intend to borrow or lend in the future. The eurodollar contract is used to hedge against changes in the yield curve over numerous years.

Assume a corporation learns in September that it will need to borrow $8 million in December to complete a transaction. Remember that each eurodollar futures contract represents a $1 million three-month time deposit. The corporation may protect itself against an increase in interest rates during that three-month period by selling eight December eurodollar futures contracts for the $8 million required for the acquisition.

The price of eurodollar futures represents the expected London Interbank Offered Rate (LIBOR) at the time of settlement, which is December in this instance. The corporation gains from rising interest rates by short selling the December contract, which results in lower December eurodollar futures pricing.

Assume that on September 1, the December eurodollar futures contract price was precisely $96.00, meaning a 4.0% interest rate, and that when the contract expires in December, the final closing price is $95.00, representing a 5.0% interest rate. If the corporation had sold eight December eurodollar options at $96.00 in September, it would have benefited by 100 basis points (100 x $25 = $2,500) on eight contracts, for a total profit of $20,000 ($2,500 x 8).

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In this manner, the corporation was able to counteract the increase in interest rates by essentially locking in the expected LIBOR for December, which was reflected in the price of the December eurodollar contract at the time the short sale was completed in September.

Speculating With Eurodollar Futures

The price of eurodollar futures is heavily influenced by the Federal Reserve’s policy choices as an interest rate instrument. As a consequence, volatility in the eurodollar market is often seen around key Federal Open Market Committee (FOMC) pronouncements and data releases that may impact Federal Reserve monetary policy.

A shift in Federal Reserve policy toward lower or higher interest rates may take years, and eurodollar futures are affected by these big monetary policy shifts.

Eurodollar futures are an intriguing alternative for traders who use trend-following methods because to their long-term moving characteristics. Consider the figure below, which shows the eurodollar trending higher for 15 straight months before falling for 27 consecutive months between 2000 and 2007.

Eurodollars have historically shown long periods of trending price movement between long periods of trading sideways. Image by Julie Bang © Investopedia2020

The high levels of liquidity, along with relatively low intraday volatility (i.e. within one day), present an opportunity for traders who trade in a “market creating” approach. Traders that utilize this non-directional (neither bullish nor bearish) technique place orders on the bid and offer at the same time, hoping to capture the bid-ask spread. Traders in the eurodollar futures market also use more complex methods such as arbitrage and spreading against other contracts.

The Bottom Line

Retail traders often skip eurodollars in favor of futures contracts with more short-term volatility, such as the E-mini S&P or crude oil. However, the eurodollar market’s high liquidity and long-term moving characteristics give fascinating possibilities for both small and major futures traders.

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