Question

Suppose you have an agreement from a bank for a $10 million loan which begins in January 2011 and runs through June 2011. According to the loan contract, you are to pay LIBOR + 100 basis points. For example if LIBOR is 4%, you pay 5%. The interest rate on the loan will be 4 based on the 3-month LIBOR rate in January 2011. You would like to hedge your interest cost using the Eurodollar futures market. Suppose February 2010 the price of a January 2011 Eurodollar futures contract is $98.00. You could lock in a hedged loan rate of _

A. 2% by shorting January 2011 futures.

B. 3% by shorting January 2011 futures.

C. 3% by longing January 2011 futures.

D. 5% by longing January 2011 futures.

Answer 1

Not to be confused with the euro/U.S. dollar (EUR/USD) currency pair or the euro currency, eurodollars are a type of U.S. dollar deposit held in a bank outside of the United States.

Eurodollar futures prices are expressed numerically using 100 minus the implied 3-month U.S. dollar LIBOR interest rate. In this way, a eurodollar futures price of $96.00 reflects an implied settlement interest rate of 4%, or 100 minus 96. Price moves inverse to yield.

The company is able to offset the rise in interest rates, effectively locking in the anticipated LIBOR for December as it is reflected in the price of the December eurodollar contract at the time it made the short sale in September.

Hence, when the Eurodollar futures contract is trading at $98.00, you could lock in a hedged loan rate of 2% (100 - $98) by shorting January 2011 futures. The correct option is Option A.