Saturday, August 15, 2009

Eurodollar interest rate futures(5)

When it is desired to hedge against changes in the interest rate for periods longer than three months, it is possible to do so by acquiring a series of successive future contracts. For example, if someone wished to fix his return for a one-year period starting in September, he would simply purchase a December futures contract, a March futures contract, a June futures contract, and a September future contract. As the December contract came to an end, it would be replaced by (rolled over into) the March contract and that would be rolled over into the June contract and that into the September contract. He would thus be protected against shifts in the overall level of interest rate. This collection of multiple short-term three-month futures contracts to hedge changes in interest rates for a longer period is referred to as a Eurodollar strip. Eurodollar futures can thus be used to hedge as much as seven years out. Another way to hedge a more distant future than is available directly in the futures markets is to acquire a shorter-term futures contract or strip and replace it with new contracts closer to the desired time period as each of the shorter contracts gains in liquidity. For example, you could acquire the strip just discussed, hold it for the first three-month period and roll it over into a new twelve-month strip, and keep doing this until the desired period is attained, say , three years from now . Such hedging wit a short-term futures contract that is subsequently replaced with other contracts is referred to as a stack.
Finally, it has become common to combine interest rate hedges with currency hedges to provide interest rate protection in a particular currency. For example, a eurobanker in France may be faced with needing to guarantee a French customer an interest rate for a future three-month loan in Swiss francs. To do so, the banker would lock in the future Eurodollar interest rate with a Eurodollar futures contract, and then couple that with both a forward contract to buy Swiss francs at the time the loan is made and a forward contract to sell Swiss francs three months later, when the loan is repaid.

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