Introduction

In the realm of interest rate futures, understanding the final contract price for Eurodollar futures is crucial. This chapter delves into the process of calculating the final contract price on a Eurodollar futures contract and highlights the key differences between Eurodollar futures and Forward Rate Agreements (FRAs). By comprehending these aspects, participants in the financial markets can make informed decisions regarding interest rate risk management.

Calculating the Final Contract Price on a Eurodollar Futures Contract:

The final contract price on a Eurodollar futures contract depends on the difference between the futures rate and the actual prevailing interest rate at the time of contract expiration. This difference is termed the “price alignment interest” (PAI). The formula to calculate the final contract price (FCP) is as follows:

$$\text{Final Contract Price (FCP) = 100 - Futures Rate + PAI}$$

Where:

• Futures Rate: The agreed-upon interest rate in the Eurodollar futures contract.
• PAI: Price Alignment Interest, calculated based on the difference between the futures rate and the actual reference rate.

The PAI reflects the changes in interest rates since the contract’s inception. Positive PAI results in a reduction of the contract price, while negative PAI increases the contract price.

Comparing Eurodollar Futures to FRAs

Eurodollar futures and FRAs are both tools for managing interest rate risk, but they differ in several aspects:

1) Contract Structure

• Eurodollar Futures: Traded on exchanges, these contracts offer standardized terms and are more liquid.
• FRAs: Over-the-counter (OTC) agreements customized to specific needs.

2) Underlying Rates

• Eurodollar Futures: Based on LIBOR rates for specific future periods.
• FRAs: Agreements on future interest rates between two parties.

3) Delivery and Settlement

• Eurodollar Futures: Physical delivery is rare; most contracts are cash-settled based on the final contract price.
• FRAs: No physical delivery; cash settlement based on the difference between the contracted rate and the prevailing market rate.

4) Flexibility

• Eurodollar Futures: Limited flexibility due to standardized terms.
• FRAs: Greater flexibility in terms and dates due to customization.

5) Counterparty Risk

• Eurodollar Futures: Lower counterparty risk due to exchange-traded nature.
• FRAs: Higher counterparty risk due to OTC nature.