Interest Rate Predictions

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

Interest rates depend on several factors and fluctuate constantly. It is therefore difficult to predict interest rates. 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. These were originally held in European banks when the term “Eurodollar” was coined. These eurodollars are now held in different banks around the world.

These deposits are made beyond the US borders and are therefore not subject to the Federal Reserve’s jurisdiction. 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. Initial trading was done at CME under the symbol ED. They are quarterly contracts that expire in March, June and September. 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. It is a market estimate for the 3-month US Dollar London Interbank Offered rate (LIBOR), interest rate that will be applicable on the contract’s settlement.

A price index of 95.00 would be obtained if you have an interest rate at 5%. 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. Eurodollar futures are a popular tool for investors to predict interest rates. 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 futures have an inverted relationship to interest rates.

A company may be aware it will need to borrow $4m in June. However, it can short-sell four Eurodollar futures contracts in March to hedge against rising interest rates. 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. The company can make a profit selling the contract as the interest rate rises. 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. The eurodollar market is subject to volatility due to announcements and economic releases by the Federal Reserve. These changes in Federal Reserve policy have a significant impact on 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.

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