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

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Interest Rate and Equity Futures

INTRODUCTION

Chicago Mercantile Exchange (CME) introduced the Eurodollar futures contract in 1981. 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. To give some give idea of its importance, six million contracts were traded in one day on Friday 5 June 2009.

Eurodollars

Eurodollars are simply time deposits in US dollars held in commercial banks outside the USA. The bulk of the market is based in London. The ‘Euro’ prefix is historical in origin and has nothing to do with the single common European currency. The market grew up in the years after the Second World War when large pools of dollars accumulated in London and other international financial centres outside the US.

The CME Eurodollar futures broke new ground because it is cash-settled rather than through the physical delivery of a commodity or financial asset. The technique is explained in the next section.

Cash settlement is now used for a wide range of contracts on exchanges around the world. It is used in equity index futures, so that it is 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 ...