Derivatives Demystified: A Step-by-Step Guide to Forwards, Futures, Swaps and Options

Chapter 5. Interest Rate and Equity Futures

INTRODUCTION

In 1981, Chicago Mercantile Exchange (CME) introduced the Eurodollar futures contract. It is widely used by banks and other financial institutions to hedge against changes in funding and investment rates. It is also used by traders who wish to anticipate and profit from increases or reductions in short-term US dollar interest rates. In Europe, the futures contract on short-term deposits in euros (the new single currency) traded on LIFFE has also proved to be extremely popular. In 2003 a total of 137 692 241 contracts were traded, up by 30% from 2002.

The Eurodollar futures broke new ground because it was designed to be settled in cash rather than through the physical delivery of a commodity or financial asset. This technique has now been adopted for a wide range of contracts on exchanges around the world. It is used in equity index futures, so that it is now possible to profit from or hedge against changes in the level of major stock market indices without ever actually buying or selling the underlying shares. This helps to reduce transaction costs and allows traders to take a position in equities at a fraction of what it would cost to buy and sell the underlying shares.

INTEREST RATE FUTURES

The contract specification for the three-month Eurodollar interest rate futures traded on CME is set out in Table 5.1. Eurodollars are simply time deposits in US dollars held in commercial banks outside the USA. The bulk of the market is ...