Aurora Borealis
1 September 1989 Financial Analysts Journal Volume 45, Issue 5

Interest Rate Swaps versus Eurodollar Strips

  1. Ira G. Kawaller

An interest rate swap is essentially a contract between two parties, A and B. A calculates his interest obligation on the basis of a floating rate benchmark such as LIBOR. B calculates his obligation based on a known fixed rate. A periodic adjustment is made between the two parties, commensurate with the difference between the two obligations. A swap allows A to convert from a floating rate sensitivity to a fixed rate, and it does the opposite for B. In practice, such swaps are often designed to offset, or “hedge,” existing rate exposures.

The Eurodollar futures contract sets rates on Eurodollar time deposits, beginning on a specific forthcoming date. As interest rates rise, futures prices will fall, and vice versa. The futures market participant can maintain either a long position (in which case he will benefit if yields fall) or a short position (which would benefit from rising yields). The participant will have to mark the contract to market on a daily basis and make daily cash settlements for changes in value.

Strips of Eurodollar futures are simply the coordinated purchase or sale of a series of contracts with successive expiration dates, the objective being to “lock in” a rate of return for a given term. The construction of the strip will depend on the prices of the contracts, the amount of principal plus interest received in each quarter and the number of days in each quarter. Actual return from a correctly constructed hedge should come very close to the expected return.

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