Information about Eurodollars

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.

The first transaction involving such deposits was initiated by a bank owned by the Soviet Union, which sometimes used the telex address "Eurbank". Initially dubbed "Eurbank dollars", they eventually became known as "eurodollars".^[1] The latter name became widespread because such deposits were held mostly by European banks and financial institutions. Such deposits are now available in many countries worldwide, but they continue to be referred to as "eurodollars" regardless of the location.

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.^[1]

Gradually, as a result of the successive commercial deficits of the United States, the eurodollar market expanded worldwide.

Eurodollar Futures Contract

When traded, eurodollar 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 to trade a contract for just hundreds of dollars. Trade 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 of the 3-month London Interbank Offered Rate (LIBOR). 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). Given this price construction, if interest rates rise, the price of the futures contract falls, and vice versa. This retains the expected relationship between the price of an interest rate based contract and the yield of the same contract. However, while the price/yield relationship is maintained, the bond convexity is not maintained due to the pricing of the eurodollar contracts in yield terms. If you believe that interest rates will fall, you would then buy a CME Eurodollar futures contract (and vice versa; if you believe rates will rise, you would sell a CME Eurodollar futures contract).

40 quarterly expirations are listed in the Eurodollar contract. This extends tradable contracts over ten years, which provides an excellent picture of the shape of the yield curve. Much of the trading in the contracts are concentrated in the early months of the contract, with the first year of contracts being the most heavily traded. Total open interest in the 40 contracts is over 10 million. The front month contracts are among the most liquid futures contracts in the world.

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.

A CME Eurodollar futures price is a four-digit number which without a decimal point represents a value expressed in basis points. Professional futures traders never use decimal points in writing or reading a quotation, in which a change by one unit in the price of the futures contract is known as a point. A CME Eurodollar broker would refer to a move in a Eurodollar futures price from 9585 to 9565 as a change of "20 points." The minimum move in the price of a futures contract is known as a "tick," and in the case of CME Eurodollar futures prices, a tick just happens to be one point. Although one tick is indeed the minimum move for the 11th through the 40th distant contracts of Eurodollars at the CME, the minimum move for the nearest expiring month is a quarter of a tick, and the minimum move for the 2nd through the 10th distant contracts is one half a tick.

A point 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

For the nearest expiring or “spot” month in CME Eurodollar futures (serial or quarterly), the minimum price fluctuation is 1⁄4 of a basis point or a “1⁄4 tick,” which is $6.25. For all other CME Eurodollar contracts, the minimum price fluctuation is 1⁄2 of one basis point, or a “1⁄2 tick,” which is $12.50.

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).

Finance

In finance, the prefix "euro" as in "eurodollars" or "euroyen" refer to currency deposited outside the country of their origin.

Eurodollars are time deposits denominated in United States dollars at bank branches outside the United States. The branches may belong to foreign banks, or they may be foreign branches of US banks. All that matters is that they are located outside the United States, away from US regulations. There is nothing "European" about Eurodollar deposits; a US dollar-denominated deposit in Tokyo or Caracas would likewise be deemed Eurodollar deposits. Such deposits are normally in excess of $1,000,000, and typically (although not exclusively) involve deposits placed by one financial institution with another financial institution. As such, the Eurodollar rate is reflective of a large bank's cost of funds. Trading is extensive and quite active, particularly in maturities ranging from one day to six months; there is some very light trading that may run out as far as five years.

Although paid on deposits booked elsewhere in the world, the Eurodollar rate is driven primarily by the American economy (because it represents an interest rate paid on US dollar-denominated deposits). By and large, when the Fed tightens (or is expected to raise rates within the lifetime of the deposit) the Eurodollar rate goes down, and when the Fed eases (or is expected to lower rates) the Eurodollar rate goes up.

In addition, the interest rate on Eurodollar deposits can and does vary throughout the day in response to supply and demand. This can be problematic for market participants who seek to use Eurodollar rates as benchmarks. The LIBOR rate and other similar rates were therefore developed for that purpose, representing a snapshot of the Eurodollar market in a specific locality and point in time (11:00 a.m. in London in the case of LIBOR).

Eurodollar rates should not be confused with the currency called the euro, which is the common currency of some members of the European Union. Prior to the introduction of this currency, traders in Eurodollars would colloquially refer to them as "Euros", but this practice has diminished since 2002.

The market for Eurodollar futures has grown to be highly liquid with the introduction of online trading such as via CME Globex®.

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

Notes

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.

External links

• Eurodollar Deposit is an overview article
• 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.

•  • [ e] Currencies named dollar or similar
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