Your bank is a regular borrower in the Eurodollar market. On August 9, 2019, the head of the funds management division decides to hedge the bank’s interest cost on a $10 million three-month Eurodollar issue scheduled for November 2018. On August 9, the bank could issue $10 million in three-month Eurodollars at
1.61 percent. The corresponding futures rates for three-month Eurodollar futures contracts are 1.83 percent (December 2019), 2.01 percent (March 2020), and 2.38 (June 2020).
1. What is the bank’s specific cash market risk on August 9, 2018? Should the bank buy or sell Eurodollar futures to hedge its borrowing costs? Explain how the hedge should work.
2. Which Eurodollar futures contract should the bank use? Explain why it is best. Assume that the bank takes the futures position that you recommend in Question 1 above at the rate available on August 9, 2018. On November 6, 2018, the bank issues $10 million in Eurodollars at 3.25 percent. Coincidentally, it closes out (reverses) its futures position when the futures rate on the contract you chose equals 3.33 percent. Calculate the profit or loss on the futures trades, the opportunity gain or loss in the cash market, and the effective return or cost to the bank on its Eurodollar issue.
3. Suppose instead that interest rates declined after August 9 and the bank actually issued Eurodollars at 1.47 percent. Assuming it closed out its futures position at 1.59 percent, calculate the same profit/loss and return/cost components as above.
4. It is important to note that the prevailing futures rate at the time a hedge is initiated reflects consensus information regarding the future level of cash market rates. Explain conceptually why the effectiveness of hedging is influenced by the accuracy of the futures rate.