Saturday, August 15, 2009

Eurodollar interest rate futures(4)

Similarly, potential borrowers in the future can guard against a rise in the borrowing rate by selling a future contract for the period in the future during which they are going to be in need of borrowing funds (that is, a contract to acquire funds at a specific loan rate). This activity is referred to as a short hedge. If interest rates rise by the time that the loan is needed, the seller receives the funds associated with the daily margin adjustment, which can be used to reduce the amount of the necessary loan. The result is that the borrower has the necessary funds over the period needed at approximately the contracted rate because the lower amount of the required borrowing offsets the higher market interest rate. More simply, the gain from future contracts offsets the increased cash borrowing costs. In fact, the borrower actually ends up a slightly lower rate than would have been the case if the same hedge had been made using the forward market. It should be pointed out that the Eurodollar contract is unlikely to provide a perfect hedge since there is unlikely to be a perfect match between the hedging instrument and the financial instrument being hedged. The lack of a perfect hedge is often referred to as basis risk.

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