Eurodollar
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Eurodollars are deposits denominated in United States dollars at banks outside the United States, and thus are not under the jurisdiction of the Federal Reserve. Consequently, such deposits are subject to much less regulation than similar deposits within the United States, allowing for higher margins. There is nothing "European" about Eurodollar deposits; a US dollar-denominated deposit in Tokyo or Caracas would likewise be deemed Eurodollar deposits. Neither is there any connection with the euro currency.
More generally, the "euro" prefix can be used to indicate any currency held in a country where it is not the official currency: for example, euroyen or even euroeuro.[1]
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[edit] History
Gradually, after the Second World War, the amount of U.S. dollars outside the United States increased enormously, both as a result of the Marshall Plan and as a result of imports into the U.S., which had become the largest consuming market after peace was reestablished in Europe.
As a result, enormous sums of U.S. dollars were in custody of foreign banks outside the United States. Some foreign countries, including the Soviet Union, also had deposits in U.S. dollars in American banks, granted by certificates.
During the Cold War period, especially after the invasion of Hungary in 1956, the Soviet Union feared that its deposits in North American banks would be frozen as a retaliation. It decided to move some of its holdings to the Moscow Narodny Bank, a Soviet-owned bank with a British charter. The British bank would then deposit that money in the US banks. There would be no chance of confiscating that money, because it belonged to the British bank and not directly to the Soviets. On February 28 1957, the sum of $800,000 was transferred, creating the first eurodollars. Initially dubbed "Eurbank dollars" after the bank's telex address, they eventually became known as "eurodollars"[2] as such deposits were at first held mostly by European banks and financial institutions.[2]
Gradually, as a result of the successive commercial deficits of the United States, the eurodollar market expanded worldwide.
[edit] Eurodollar Futures Contract
The Eurodollar futures contract refers to the financial futures contract based upon these deposits, traded at the Chicago Mercantile Exchange (CME) in Chicago. Each CME Eurodollar futures contract has a notional or 'face value' of $1,000,000, though the leverage used in futures allows one contract to be traded with a margin of just hundreds of dollars. Trading in Eurodollar futures is extensive, thus offering uniquely deep liquidity. Prices are quite responsive to Fed policy, inflation, and other economic indicators.
CME Eurodollar futures prices are determined by the market’s forecast for the delivery month of the 3-month LIBOR interest rate. The futures prices are derived by subtracting that implied interest rate (yield) from 100.00. For instance, an anticipated interest rate of 5.00 percent will translate to a futures price of 95.00 (100.00 – 5.00 = 95.00). On the expiry day of a contract, the contract is valued using the current fixing of 3-month LIBOR. As with other fixed rate instruments, if the yield rises, the price of the futures contract falls, and vice versa. If you believe that interest rates will fall, you would then buy a CME Eurodollar futures contract because you expect the contract price to rise (and vice versa; if you believe rates will rise, you would sell or short-sell a CME Eurodollar futures contract because you expect the contract price to fall). This retains the normal inverse relationship between the price and the yield of interest rate securities. However, the bond convexity is not maintained due to the pricing of the Eurodollar contracts in yield terms.
40 quarterly expirations and 4 serial expirations are listed in the Eurodollar contract. [3] This means that on January 1, 2008, the exchange will list 40 quarterly expirations (March, June, September, December for 2008 through 2017), the exchange will also list another four serial (monthly) expirations (January, February, April, May 2008). This extends tradable contracts over ten years, which provides an excellent picture of the shape of the yield curve. The front month contracts are among the most liquid futures contracts in the world, with liquidity decreasing for the further out contracts. Total open interest for all contracts is typically over 10 million.
The CME Eurodollar futures contract is used to hedge interest rate swaps. There is an arbitrage relationship between the interest rate swap market, the Forward Rate Agreement market and the Eurodollar contract. CME Eurodollar futures can be traded by implementing a spread strategy among multiple contracts to take advantage of movements in the forward curve for future pricing of interest rates.
Eurodollar contracts are extremely popular due to their ability to accurately hedge the mortgage market debt. The correlation with mortgage market debt is extremely high, higher than the CBOTs Treasury Futures contracts.
In the past, the minimum price fluctuation of a Eurodollar futures price was 0.01 (for example, a price change from 96.44 to 96.45). A price change of 0.01 is referred to as a "tick" and represents a change in yield of a basis point. The exchange has reduced over time the minimum price fluctuation of the contract because of increasing liquidity. As of December 2007, these are 0.0025 (a quarter tick) for the nearest expiring month and 0.005 (a half tick) for all other months.[3] This notation is confusing because strictly one tick is defined as the minimum price fluctuation of a futures contract.
A tick in CME Eurodollar futures is worth $25.00, based on the $1,000,000 notional value of this contract, as calculated below:
$1,000,000 notional value x .0001 (one basis point) x 90/360 (three month) deposit period = $25.00.cxcxc
[edit] Eurodollar sweeps
In United States Banking, eurodollars are a popular option for what are known as "sweeps". By law, banks aren't allowed to pay interest on corporate checking accounts. To accommodate larger businesses, banks may automatically transfer, or sweep, funds from a corporation's checking account into an overnight investment option to effectively earn interest on those funds. Banks usually allow these funds to be swept either into money market mutual funds, or alternately they may be used for bank funding by transferring to an offshore branch of a bank (thus a eurodollar).
[edit] See also
- Swaps
- Forward Rate Agreement
- LIBOR
- TED spread
- Eurocurrency
- Petroeuro
- Eurozone
- Currencies related to the euro
- The eurodollar is also a fictional currency used worldwide in the setting of Cyberpunk 2020
[edit] Notes
- ^ Eurodollar Deposit is an overview article
- ^ a b "Adam Smith", Paper Money, London: Macdonald & Co, 1982, p. 122
- ^ a b CME Eurodollar Contract Specifications. Accessed 09 December 2007.
[edit] Bibliography
- Boberski, David Valuing Fixed Income Futures. 1st edition, 2006
- Ratti, B. Comércio Internacional e Câmbio. 9ª Edição. São Paulo, Brazil, Edições Aduaneiras, 1997
- Sandroni, P. Novíssimo Dicionário de Economia. 5ª Edição. São Paulo, Editora Best Seller, 2000.
[edit] External links
- the British Bankers Association compiles Libor rates earned on Eurodollars.
- Convexity bias is a persistent bias in the pricing of Eurodollar futures relative to the forward market.
fr:Eurodollar id:Eurodolar ja:ユーロカレンシー pt:Eurodólar uk:Євродолари
