A COMMENT ON

A HEDGING DEFICIENCY
IN EURODOLLAR FUTURES
IRA G. KAWALLER

Professor Chances analysis shows that hedge results from eurodollar

futures are imperfect; and he credits the futures contract design as being
the source of the error. This comment argues that the unanticipated outcomes that Professor Chance evidences stem not from the design of the
contract, but rather from improperly sizing hedge transactions. If appropriately sized hedges are used, perfect hedge outcomes in fact, will follow.
2007 Wiley Periodicals, Inc. Jrl Fut Mark 27:187193, 2007

In his article that appeared in the February 2006 issue of this Journal,
Professor Don Chance postulates that the design of the eurodollar
futures contract is deficient, in that the futures price does not converge
to the spot price. The consequence of this design is that hedge results
will necessarily be imperfect. I tend to look at the issue with a distinctly
different perspective resulting in a contrary conclusion.
The eurodollar futures contract is commonly thought to be a pricefixing mechanism that locks in offered rates on 3-month eurodollar

For correspondence, Kawaller & Co., 162 State Street, Brooklyn, NY 11201; e-mail: kawaller@
kawaller.com
Received February 2006; Accepted May 2006

Ira G. Kawaller is the founder of Kawaller & Company, LLC and the managing partner
of the Kawaller Fund. The former is a consulting company that specializes in assisting
commercial hedgers in their use of derivatives; the latter is a derivatives-based hedge
fund.

The Journal of Futures Markets, Vol. 27, No. 2, 187193 (2007)

2007 Wiley Periodicals, Inc.
Published online in Wiley InterScience (www.interscience.wiley.com).
DOI: 10.1002/fut.20253

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Kawaller

time deposits. The value dates of the underlying deposits are third
Wednesdays of the expiration month (e.g., the third Wednesday of
March, June, September, or December).1 The precise rate that the
futures contract secures is found simply by subtracting the futures price
from 100. For example, a futures price of 95.00 reflects the capacity to
lock up a 5% offered rate on the underlying 3-month deposit. Given this
convention, it should be clear that as interest rates rise, futures prices
fall, and vice versa.
Presumably, Professor Chance would argue that the hedger would
likely end up with a different resulti.e., somewhat different from 5% in
the above example. I hope to demonstrate that the perfect result is, in
fact, obtainable; however, to realize that perfect result, the hedge has to be
implemented properly. Professor Chances imperfect result is a function
of an improperly sized hedge, not the fault of the contract design.
THE EURODOLLAR FUTURES
CONTRACT DESIGN
Eurodollar futures expire two London business days before the third
Wednesday of the contract month (i.e., on the trade date for a spot
eurodollar deposit with a settlement date of the third Wednesday).
Following expiration, any participant who had an open position as of the
expiration would be required to make a final mark-to-market adjustment;
then no further obligations or responsibilities would remain. The final
settlement price is set equal to 100 minus the spot 3-month London
Interbank Offered Rate (LIBOR) on the expiration day, as reported
by the British Bankers Association (BBA). That is, contrary to Professor
Chances assertion, the final settlement price perfectly reflects spot
3-month LIBOR. The Chicago Mercantile Exchange (CME) captures
the BBA LIBOR quotation on the expiration date and then settles the
contract to the final price that reflects exactly this yield. You cant get
better convergence than that!
This comment argues that if the exposure to be hedged is identical
to the underlying of the associated futures contract, the hedged outcome
should be perfect. If, however, these two components of the hedging
relationship are not identical, then some degree of imprecision of the
hedge will prevail. This seeming ineffectiveness, however, is simply
the traditional basis risk issue that affects any hedge where the exposure and the instrument that underlies the futures contract exhibit any
1

Forty quarterly expiration months are available, along with the four most-imminent nonquarterly
months. The nonquarterly expirations are known as serial months.

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Comment

differenceswhether in connection with timing or with regard to the

quality of the underlying instrument or commodity. In any case, if the
exposure being hedged were a 3-month security priced at LIBOR (or
LIBOR
a known and constant spread) as of two London business days
before the third Wednesday of the month, the issue of basis risk would
seem to be mootbut it may not be if the day counts associated with
the hedged item and the eurodollar futures are not identical. A discrepancy of this type is typical as the futures contract design imposes the
assumption of a 90-day quarter,2 but most calendar quarters are either
91 or 92 days.
Consider the case where a hedger intends to issue 3-month
eurodollar deposits with a value date equal to the third Wednesday of
the March (priced two London business days earlier). In this case, a
difficulty arises because the 3-month maturity associated with the cash
deposit will typically have a different day count from the 3 months associated with the futures contract. That is, by convention, interest on
eurodollar deposits accrues on the basis of the actual-over-360 day
count convention, where maturity dates are set to be the same calendar
day as the deposits start date, or the next business day following.3 In
our example, given an issue date of, say, March 15th, the maturity
would be June 15th, and thus the deposit would happen to have a 92day maturity. Meanwhile, the design of the eurodollar futures contract
imposes the presumption of a 90-day maturityconsistent with the
design feature that assigns a $25 basis point value to price changes in
the futures contract, i.e., $25  $1 million  0.0001  (90
360).
This design feature canand shouldbe accommodated for, by
properly sizing the hedge to reflect the differences between the two
respective interest rate sensitivities. The appropriate number of futures
to use is simply found by dividing the basis point value of the exposure
by the basis point value of the contract. Mathematically, the hedge ratio
(or the number of futures contracts required) to hedge a $1 million
deposit exposure would be found as follows:

N

$1 million  0.0001  a

DaysEXP
b
DaysEXP
360

90
90
$1 million  0.0001  a
b
360

The value of $25 per 0.01 price change is reflective of the basis point value of a $1 million deposit
with a 90-day maturity.
3
This convention is overridden if the next business day would bring the maturity day into the following calendar month. In that case, the maturity date would be made earlier, rather than later.
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where N is the hedge ratio and DaysEXP is day count from the start date
of the exposure to the maturity.
In the above example, DaysEXP would equal 92, and thus the required
number of futures contracts would be 92
90  1.022222 . . . per million.
Clearly, if one were only hedging a million dollars of exposure, this precision would be lost in the rounding, and a one-for-one hedge would be the
appropriate practical solution; but, in fact, this hedge (or any one-to-one
hedge) would be too small by more than 2%. Put another way, the onefor-one hedge only covers 97.8% of the risk. The remaining portion of risk
would not be hedged. Thus, the risk would be largely mitigated, but not
fully offset. This conclusion, however, only holds for the one-for-one
hedge construction. Assuming if the magnitude of the exposure allowed
for perfect hedge sizing, the risk could be entirely offset.
An Example
This point can be demonstrated using an example that assumes that fractional contracts could be transacted. Extending the above case, where
the DaysEXP is 92 and thus the required number of futures contracts are
92
90 per million, suppose the futures are originally sold at a price of
95.00. Here, the perfect result would be to realize an ex post LIBOR of
5% for the prospective liability subject to risk. In fact, as long as the spot
LIBOR and the final futures price reflect the same yieldwhich they
will by contract design this outcome is assured.4 This result is demonstrated for two cases. In the first case, LIBOR is assumed to have moved
to 4% as of the common date when the futures expire and the rate is
determined for the exposure; in the second case LIBOR is assumed to
have moved to 6%.
The interest expense is simply Principal ($1 million) times the terminal spot LIBOR times Time ( 92
360); the futures result reflects
the 200 basis point moves in either direction times the $25 value of a
basis point, times the hedge ratio; and the combined results simply
add futures losses to (or deduct futures gains from) the interest paid.
The effective yield derives from dividing the combined results by the
$1 million principal and then annualizing this simple interest rate by
multiplying by 360
92.
4

This perfect hedge outcome does ignore the incremental earnings associated with the potential to
invest variation margin gains or the costs associated with financing variation margin losses.
Professor Chance recognized that same concern. He (and I) effectively brush aside this concern by
assuming that rate changes occur only on the last day of the hedgeeffectively causing the value of
these incremental effects to become zero.

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Comment

This example illustrates two critical points:

1. As long as the final futures price perfectly corresponds to the cash
LIBOR paid (or received) on the deposit being hedged, if the hedge
ratio properly reflects the correct value of a basis point for the exposure, the ex post hedge result will perfectly reflect the price of the
futures contract as of the date that the hedge is initiated.
2. Spot LIBOR as of the date the hedge is initiated is irrelevant. Put
another way, the effective rate that will be realized from a properly
constructed futures hedge is the rate that corresponds to the starting
futures priceirrespective of the spot LIBOR as of the hedges start
date.
The above presentation begs the question: What happens in the
case where perfect convergence does not occur? That is, either because
of differences in timing for the proposed exposure versus the period
associated with the 3 months underlying the futures contract (i.e., starting on the third Wednesday of the contract month), or because the
deposit being hedged might be priced at a non-zero spread over/under
LIBOR? These circumstances are illustrated in Tables I and II.
In these two cases, the example is constructed where the rate used
for the interest accrual on the exposure differs from the rate reflected by
the final futures price by 10 basis points. This non-convergence effect
feeds directly to the bottom line, basis point for basis point, such that
instead of realizing the 5% outcome consistent with trading the futures
at 95.00, the hedger realizes this 5% adjusted by the basis effect as of the
date the hedge is terminatedin these cases, 5.10%. Thus, to the extent
that hedgers can accurately anticipate the ending basis conditions, the
TABLE I

Alternative Hedge OutcomesPerfect Convergence

Futures price at hedge inception

LIBOR at hedge termination
Futures price at hedge termination
Rate used for interest accrual on the exposure
DaysEXP
Hedge ratio
Interest paid on the liability
Futures results
Combined results
Effective yield

Case 1

Case 2

95.00
4.00%
96.00
4.00%
92
1.02222

95.00
6.00%
94.00
6.00%
92
1.02222

10,222.22
(2,555.56)
12,777.78
5.00%

15,333.33
2,555.56
12,777.78
5.00%

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TABLE II

Alternative Hedge OutcomesImperfect Convergence

Futures price at hedge inception

LIBOR at hedge termination
Futures price at hedge termination
Rate used for interest accrual on the exposure
DaysEXP
Hedge ratio
Interest paid on the liability
Futures results
Combined results
Effective yield

Case 1

Case 2

95.00
4.00%
96.00
4.10%
92
1.02222

95.00
6.00%
94.00
6.10%
92
1.02222

10,477.78
(2,555.56)
13,033.33
5.10%

15,588.89
2,555.56
13,033.33
5.10%

ex post results may still be anticipated, preciselybut only if the hedge is

implemented with the appropriate hedge ratio.
Critically, these results are perfect only in an accounting sense.
That is, the above examples demonstrated that except for rounding error,
it is possible to construct a hedge where the ex post accounting result
will match ex ante expectations. This result, however, is contingent upon
futures gains or losses being recognized in earnings concurrently with
the recognition of the cash interest expenses or revenues associated with
the exposure; and, importantly, this treatment is precisely the treatment
prescribed by under cash flow hedge accounting rules.
One could argue that being perfect in an accounting sense is different
from being perfect in an economic sense; and I would agree. But this criticism applies to all futures contractsnot just eurodollars. That is, because
futures hedge results are generated daily through the process of daily markto-market variation settlement adjustments, the perfect economic hedge
(as opposed to the perfect accounting hedge) would be one that offsets the
present value of the forthcoming price effects of the exposure, whereas the
hedge devised in the above example only addresses the nominal amount of
the price effect without taking into account any timing differences.
Though conceptually elegant, hedges constructed to offset these
present value effects (commonly referred to as tailed hedges) are problematic, in that they require making dynamic adjustments as interest rates
change and/or as time goes by. Ultimately, however, as the hedge period
reaches its end and the present value factor approaches unity, the size of
the tailed hedge position will approach that of the untailed hedge.5
5

See Kawaller (1994) for a more complete discussion of the issues relating to tailed and untailed
Eurodollar futures hedges.

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Comment

As a practical matter, tailed hedges tend to be preferred by firms

that operate in a mark-to-market accounting environment (such as trading or investment companies), but other enterprises that seek to defer
the recognition of hedge results will tend not to tail their hedges and
seek hedge accounting treatment; and for these firms, the perfect
accounting result is the primary objectivean objective that can be realized with eurodollar futures.
CONCLUSION
The source of the difference between the perspective of the original
article by Don Chance and that of this comment is that different methodologies are being applied to determine the size of the hedge. I propose a
method for sizing a eurodollar futures hedge that equates the dollar values
of the basis points for the hedged item and the futures position, respectively; and I show that with such a hedge construction, hedgers should
realize perfect hedging results. Professor Chance demonstrates imperfect
hedge results in his analysis, and he attributes the seemingly deficient
outcomes to flaws in the design of the futures contracts. I believe the fault
lies with the methodology for sizing the hedge positions. With an appropriately sized hedge, there should be no surprises.
BIBLIOGRAPHY
Chance, D. M. (2006). A hedging deficiency in eurodollar futures. Journal of
Futures Markets, 26(2), 186207.
Kawaller, I. G. (1992). Choosing the best interest rate hedge ratio. Financial
Analysts Journal, 48(5), 7477.
Kawaller, I. G. (1994). Comparing eurodollar strips to interest rate swaps.
Journal of Derivatives, 2, 6779.

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