Question

First American Bank is planning to make a $20 million short-term loan to Midwest Mining Company. In the loan contract, Midwest agrees to pay the principal and an interest of 12 percent (annual) at the end of 180 days. Since First American sells more 90-day CDs (Certificates of Deposits) than 180-day CDs, it is planning to finance the loan by selling a 90-day CD now at the prevailing LIBOR of 8.25 percent (compounded annually), then 90 days later (mid-September) sell another 90-day CD at the prevailing LIBOR. The bank would like to minimize its exposure to interest rate risk on its future CD sale by taking a position in a September Eurodollar futures contract trading at 92 (IMM index).

a) Should the bank buy or sell Eurodollar futures contracts? Explain why.

b) How many September Eurodollar futures contracts would First American Bank need in order to effectively hedge its September CD sale against interest rate

changes?

Answer 1

a) Eurodollar futures provide an effective means for companies and banks to secure an interest rate for money it plans to borrow or lend in the future. In our example after 90 days First American Bank need to sell another 90-day CD at the prevailing LIBOR. Bank should sell Eurodollar futures contracts in order to hedge the interest rate risk on its future CD sale.

b) In mid-September First American Bank needs to borrow $20 million. As each eurodollar futures contract represents a $1 million time deposit with a three-month maturity. The First American Bank can hedge against an adverse move in interest rates during that three-month period by short selling twenty eurodollar futures contracts, representing the $20 million needed.