The December Eurodollar futures contract is quoted as 98.40...

The December Eurodollar futures contract is quoted as 98.40 and a company plans to borrow $$\$ 8$$ million for three months starting in December at LIBOR plus $0.5 \%$. (a) What rate can the company lock in by using the Eurodollar futures contract? (b) What position should the company take in the contracts? (c) If the actual three-month rate turns out to be $1.3 \%$, what is the final settlement price on the futures contracts. Explain why timing mismatches reduce the effectiveness of the hedge.

The December Eurodollar futures contract is quoted as 98.40 and a company plans to borrow $$\$ 8$$ million for three months starting in December at LIBOR plus $0.5 \%$.
(a) What rate can the company lock in by using the Eurodollar futures contract?
(b) What position should the company take in the contracts?
(c) If the actual three-month rate turns out to be $1.3 \%$, what is the final settlement price on the futures contracts.
Explain why timing mismatches reduce the effectiveness of the hedge.

Key Concepts

Hedge Effectiveness and Timing Mismatches

Hedge effectiveness refers to how well a hedging strategy reduces risk, and timing mismatches occur when the maturities or timing of the hedging instrument do not perfectly align with the underlying exposure. Such mismatches can diminish the expected risk reduction because changes in interest rates may affect the hedge and the exposure differently over time, leading to a residual basis risk that lessens the overall effectiveness of the hedge.

Futures Contract Settlement

The settlement price of a futures contract is the final value, based on the underlying interest rate or index, used to calculate gains or losses upon contract expiration. In the context of eurodollar futures, the settlement price is determined by subtracting the actual three?month LIBOR rate from 100, reflecting the realized interest rate environment at the time the contract matures.

Eurodollar Futures

Eurodollar futures are standardized financial contracts that allow market participants to hedge or speculate on the future direction of short-term interest rates, specifically the three?month LIBOR. They are quoted as 100 minus the implied annualized interest rate, and provide a mechanism to lock in borrowing or lending rates, allowing users to manage interest rate risk in their portfolios.

LIBOR

The London Interbank Offered Rate (LIBOR) is a benchmark interest rate at which major global banks lend to one another in the international interbank market for short-term loans. It serves as a reference rate for numerous financial instruments and contracts, including eurodollar futures, and is essential in determining the cost of borrowing in many financial and corporate transactions.

Interest Rate Hedging

Interest rate hedging involves taking positions, often in derivative instruments such as futures contracts, to protect against the risk of adverse movements in interest rates. By locking in a future borrowing rate today, an entity can reduce the uncertainty associated with fluctuations in market interest rates, thereby stabilizing financing costs over time.

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