Question

Suppose the September Eurodollar futures contract has a price of 96.4. You plan to borrow $50m for 3 months in September at LIBOR, and you intend to use the Eurodollar contract to hedge your borrowing rate.
a.What rate can you secure?
b.Will you be long or short the Eurodollar contract?
c.How many contracts will you enter into?
d.Assuming the true 3-month LIBOR is 1% in September, what is the settlement in dollars at expiration of the futures contract? (For purposes of this question, ignore daily marking-to-market on the futures contract.)

Answer 1

Answer:

Explanation:

Definition of simple terminologies ;

• A contractual agreement is an agreement which is made on future exchanges in order to buy or sell goods at a fixed price at a specified time period.

• LIBOR stands for London interbank offered rate which is the rate at which  banks borrow money from other banks in london market. this rate is a fixed term by the british bankers association.

a) The implied LIBOR of the September Eurodollar futures of 96.4 is =  100 96.4 /400-=0.9%

(b) As we want to borrow money, it implies buying protection against high interest rates, which means low Eurodollar future prices. We will short the Eurodollar contract.

c) Number of contact to be entered into = One Eurodollar contract which is based on a $1 million 3-month deposit. As such, entering into hedge a loan of $50M, will automatically implies entering into 50 short contracts.

d) A true 3-month LIBOR of 1% means an annualized position (annualized by market conventions) of 1% x 4 = 4%. Therefore, our 50 short contracts will pay: [96.4 − (100 − 4) × 100 × $25] × 50 = $50,000.

The increased interest rate has  made the loan more expensive as such, the loss to exposure  will be compensated hence we have to pay the following amount ; ($50,000,000 x 0.01) - $50,000

= $450,000