Eurodollars

What are eurodollars?

US dollar deposits placed with banks outside the US. Holders may include individuals, companies, banks, and central banks. (Source: CFTC)

Eurodollars are deposits denominated in United States dollars at banks outside the United States, and thus are not under the jurisdiction of the Federal Reserve. Consequently, such deposits are subject to much less regulation than similar deposits within the United States, allowing for higher margins.

Historically, such deposits were held mostly by European banks and financial institutions, and thus became known as "eurodollars". Such deposits are now available in many countries worldwide, but they continue to be referred to as "eurodollars" regardless of the location.

Futures Contract

At the same time, eurodollar refers to the financial futures contract based upon these deposits. Traded at the Chicago Mercantile Exchange (CME) in Chicago, the contract has a notional or 'face value' of $1,000,000, though the leverage used in futures allows one to trade a contract for just hundreds of dollars. Trade in Eurodollar futures is extensive, thus offering uniquely deep liquidity. A purchase or sale is, in effect, a bet on U.S. short-term interest rates. Prices are quite responsive to Fed policy, inflation, and other economic indicators.

The price of a Eurodollar futures contract is equal to 100 minus the yield (interest rate) for the given future date. Thus, a price of 95 would imply a 5% yield on the Eurodollar deposit. If you believe that interest rates will fall, you would then buy a Eurodollar contract (and vice versa; if you believe rates will rise, you would sell a Eurodollar contract). Each "tick" (.01) on the price of a Eurodollar contract is worth $25 and is equal to one basis point (i.e., a move from 95.010 to 95.020, but the Eurodollar trades in half ticks (.005, $12.50 per contract) and quarter ticks (.0025, $6.25 per contract).

The CME eurodollar contract is used to hedge interest rate swaps. There is an arbitrage relationship between the interest rate swap market and the Eurodollar contract. Eurodollar futures can be traded by implementing a spread strategy among multiple contracts to take advantage of movements in the forward curve for future pricing of interest rates.

The front month contracts are among the most liquid futures markets in the world. The contract suite has quarterly expirations out to 10 years. Each year has a reference color, with the first year from today being referred to as 'front' months.

Finance

In finance, the prefix "euro" as in "eurodollars" or "euroyen" refer to currency deposited outside the country of their origin.

Eurodollars are time deposits denominated in United States dollars at banks headquartered outside the United States, or in foreign branches of banks headquartered within the United States. There is nothing "European" about Eurodollar deposits; a US dollar-denominated deposit in Tokyo or Caracas would likewise be deemed Eurodollar deposits. Such deposits are normally in excess of $1,000,000, and typically (although not exclusively) involve deposits placed by one financial institution with another financial institution. As such, the Eurodollar rate is reflective of a large bank's cost of funds. Trading is extensive and quite active, particularly in maturities ranging from one day to six months; there is some very light trading that may run out as far as five years.

Although paid on deposits booked elsewhere in the world, the Eurodollar rate is driven primarily by the American economy (because it represents an interest rate paid on US dollar-denominated deposits). By and large, when the Fed tightens (or is expected to tighten within the lifetime of the deposit) the Eurodollar rate goes up, and when the Fed eases (or is expected to ease) the Eurodollar rate goes down.

In addition, the interest rate on Eurodollar deposits can and does vary throughout the day in response to supply and demand. This can be problematic for market participants who seek to use Eurodollar rates as benchmarks. The LIBOR rate and other similar rates were therefore developed for that purpose, representing a snapshot of the Eurodollar market in a specific locality and point in time (11:00 a.m. in London in the case of LIBOR).

Eurodollar rates should not be confused with the currency called the euro, which is the common currency of some members of the European Union. Prior to the introduction of this currency, traders in Eurodollars would colloquially refer to them as "Euros", but this practice has diminished since 2002.

The market for Eurodollar futures has grown to be highly liquid with the introduction of online trading. (Source: Wikipedia)