Question

1. It is April 2019. A US company needs to borrow $100,000,000 for three months starting five months from now. The current 3-month LIBOR is 2.5%. The company is afraid that rates may rise during those five months before it obtains the loan. Should the company buy or sell Eurodollar futures? And how many (ignoring the present value of the basis point change)?

Which month should the futures settle/expire?

Assume that the appropriate Eurodollar future is trading at 97.4. What interest does the company pay if the 3-month LIBOR rate finishes at 95 (factoring in the gain/loss of the Eurodollar futures contracts)? Or finishes at 98? Assume each month has 30 days.

Answer 1

If Eurodollar future is bought, an increase in LIBOR rate would mean a loss for the investor in terms of interest gained. At the same time selling eurodollar, means the gain to investor from an increase in interest rate.

a) Hence, if rates rise in the next 5 months, there is a position of loss in interests of money borrowed. Selling eurodollar is the best way to hedge this position.

b) No of eurodollars should be in proportionate to the amount borrowed that is $100,000,000

c) Future should expire 5 months later from now so that we can observe the final position

d) Interest on eurodollar = 100-97.4=2.6% and 3-month LIBOR at 100-95=5%, current LIBOR = 2.5%

$100,000,000 x 2.60% x 90 / 360 = $650000

$100,000,000 x 5.00% x 90/ 360 = $1250000

differences = $600,000 [Company need to pay to to rise in interest/LIBOR]