Question

1. An investor uses 3-month Eurodollar futures contracts to lock in the rate of interest paid on a $25 million floating rate note for the next nine months.   Assume that Eurodollar futures contracts which mature in 3 months, 6 months and 9 months are traded. What should the investor do? Should the investor buy or sell contracts? How many contracts should the investor trade? Which maturities should the investor choose?

Answer 1

Eurodollar futures have a payoff as below:

• if the US interest rates rise, the long position (buyer of Eurodollar future) has a gain
• if the US interest rates fall, the short position (seller of Eurodollar future) has a gain

An investor who wants to lock in the rate of interest paid would buy a Eurodollar future. If the interest rates rise, the gain from the Eurodollar future would offset the increased interest expense. If interest rates fall, the loss from the Eurodollar future would offset the decreased interest expense. In either situation, the investor has locked into a rate of interest based on the price of the Eurodollar future

Number of contracts to trade = note amount / notional value of Eurodollar future

the underlying notional value of a Eurodollar future is $1 million

Number of contracts to trade = $25 million / $1 million

Number of contracts to trade = 25

As the note is of 9-month maturity, the investor should trade the 9-month Eurodollar futures