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SEPTEMBER 16, 1994
G
ALEN
B
URGHARDT
•W
ILLLIAM
H
OSKINS
not    e
T
here is a systematic advantage to beingshort Eurodollar futures relative todeposits, swaps, or FRAs. Because of this advantage, which we characterize as a con-vexity bias, Eurodollar futures prices should belower than their so-called fair values. Put differ-ently, the 3-month interest rates implied by Eu-rodollar futures prices should be higher than the3-month forward rates to which they are tied.The bias can be huge. As the chart shows, the bias is worth little or nothing for futures that haveless than two years to expiration. For a futurescontract with 5 years to expiration, however, the bias is worth about 17 basis points. And for acontract with 10 years to expiration, the bias caneasily be worth 60 basis points.The presence of this bias has profound impli-cations for pricing derivatives off the Eurodollar futures curve. For example, a 5-year swap yieldshould be about 6 basis points lower than theyield implied by the first 5 years of Eurodollar futures. A 10-year swap yield should be about 18 basis points lower. And the differential for a 5-year swap 5 years forward should be around 36
basis points. (These estimates are explained inExhibits 9, 13, and 14.)These are big numbers. A 6 basis point spreadis worth more than $200,000 on a $100 million5-year swap. An 18 basis point spread is worth about$1.2 million on a $100 million 10-year swap.Although the swaps market has begun torecognize this problem, swap yields still seem toohigh relative to those implied by Eurodollar fu-tures rates. (See Exhibit 15.) If so, then there isstill a substantial advantage in favor of beingshort swaps and hedging them with short Euro-dollar futures. Also, because the value of theconvexity bias depends so much on the market’sperceptions of Eurodollar rate volatilities, oneshould be able to trade the value of the swaps/Eurodollar rate spread againstoptions on forward Eurodol-lar rates. The convexity biasalso affects the behavior of the yield spreads betweenTreasury notes and Eurodol-lar strips.Students of Eurodollarfutures pricing should likethis note. The standard ap-proach to estimating the valueof the convexity bias (alsoknown as the financing bias)has been bound up in com-plex yield curve simulationsand option pricing calculus.And, although such methodscan yield reasonable enough answers, we showhow the problem can be solved much more sim-ply. For that matter, anyone armed with a spread-sheet program and an understanding of rate vola-tilities and their correlations can estimate thevalue of the convexity bias without recourse toexpensive research facilities.
G
ALEN
B
URGHARDT
SENIOR VICE PRESIDENT
 
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Eurodollar FuturesSwap
Years to expiration
Basispoints
Convexity Bias
CARR FUTURES
The Convexity Bias in Eurodollar Futures
Reprint of Dean Witter Institutional Futures publication.
CARR FUTURES
 Research Department
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CARR FUTURES
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The difference between a futures contract and a for-ward contract is more pronounced for Eurodollar futures,swaps, and FRAs than for any other commodity. In particu-lar, there is a systematic bias in favor of short Eurodollarfutures relative to deposits, swaps, or FRAs. As we show,the value of this bias is particularly large for futurescontracts with expirations ranging from five to ten years.The purpose of this note is to show•why the difference is so important for Eurodollarfutures•how to estimate the value of the difference•what traders can do about the differenceWhat we find is that the implications for swaps tradersand those who manage swaps books are particularly impor-tant. Given the rate volatilities that we have observed overthe past four years or so, it seems that market swap yieldsshould be several basis points lower than the implied swapyields that one calculates from the rates implied by Euro-dollar futures prices. Judging by current spreads betweenthese rates, it appears that the swaps market has not fullyabsorbed the implications of this pricing problem. As aresult, there still appear to be profitable opportunities forrunning a book of short swaps hedged with short Eurodol-lar futures. By the same token, this pricing problem raisesserious questions about how a swaps book should bemarked to market.
Interest Rate Swaps and Eurodollar Futures
Interest rate swaps and Eurodollar futures both aredriven by the same kinds of forward interest rates. But thetwo derivatives are fundamentally different in one keyrespect. With an interest rate swap, cash changes handsonly once for each leg of a swap and then only in arrears.With a Eurodollar futures contract, gains and losses aresettled every day. As it happens, the difference in the waygains and losses are settled affects the values of swaps andEurodollar futures relative to one another. In particular,there is a systematic bias in favor of a short swap (that is,receiving fixed and paying floating) and against a longEurodollar futures contract. Or, one can think of the shortEurodollar position as having an advantage over a longswap. Either way, because swap prices are so closely tied toEurodollar futures prices, it is important to know how muchthis bias is worth.The easiest way to understand the difference betweenthe two derivatives is through a concrete example thatcompares the profits and losses on a forward swap with theprofits and losses on a Eurodollar futures contract.
 A forward swap
A plain vanilla interest rate swap is simply an arrange-ment under which one side agrees to pay a fixed rate andreceive a variable or floating rate over the life of the swap.The other side agrees to pay floating and receive fixed. Theamounts of money that one side pays the other are deter-mined by applying the two interest rates to the swap’snotional principal amount.The typical swap allows the floating rate to be resetseveral times over the swap’s life. For example, a 5-yearswap keyed to 3-month LIBOR would require the value of the floating rate to be set or reset 20 times—once when theswap is transacted and every three months thereafter. Onecan think of the swap, then, as having 20 separate segmentswith the value of each segment depending on the swap’sfixed rate and on the market’s expectation today of whatthe floating rate will be on that segment’s rate setting date.The starting point for our example is the structure of Eurodollar futures prices and rates shown in Exhibit 1.These were the final settlement or closing prices on Mon-day, June 13, 1994. Each of the implied futures ratesroughly corresponds to a three-month period. The actual
Exhibit 1Structure of Eurodollar Futures Rates(June 13, 1994)Eurodollar futuresImpliedQuarterExpirationPricefuturesDays inrateperiod
(percent)
16/13/9495.444.569829/19/9494.845.1691312/19/9494.145.868443/13/9593.916.099856/19/9593.616.399169/18/9593.366.6491712/18/9593.126.889183/18/9693.086.929196/17/9692.987.0291109/16/9692.897.11911112/16/9692.747.2691123/17/9792.727.2891136/16/9792.637.3791149/15/9792.557.45911512/15/9792.427.5891163/16/9892.427.5891176/15/9892.347.6691189/14/9892.287.72911912/14/9892.167.8491203/15/9992.177.8391Swappayment6/14/99on:
Note: Given these rates, the price of a $1 zero-couponbond that matures on 6/14/99 would be .70667, and itssemiannual bond equivalent yield would be 7.0658%.
 
CARR FUTURES
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number of days covered by each of the futures contracts isshown in the right hand column. Now consider a swap that settles to the differencebetween a fixed rate and the value of 3-month LIBOR onMarch 15, 1999. On June 13, 1994, this would be a forwardswap whose rate setting date is 4-3/4 years away and whosecash settlement date is a full 5 years away. To make theexample more concrete, suppose that the forward swap’snotional principal amount is $100 million. Suppose too thatthe fixed rate for this swap is 7.83 percent, which is theforward value of 3-month LIBOR implied by the March1999 Eurodollar futures contract. This may not be strictlythe correct thing to do, but throughout this note we usefutures rates in lieu of forward rates because we have muchbetter information about the futures rates. And, althoughthe purpose of this note is to explain why the two ratesshould be different, we can use the behavior of futures ratesas an excellent proxy for the behavior of forward rates.
The value of a basis point 
Under the terms of this forward swap, if the value of 3-month LIBOR turns out to be 7.83 percent on March 15,1999, no cash changes hands at all on June 14. For eachbasis point that 3-month LIBOR is above 7.83 percent, theperson who is long the swap (that is, the person who paysfixed and receives floating) receives $2,527.78 [= (0.0001x (91/360)) x $100,000,000] on June 14, 1999. For eachbasis point that 3-month LIBOR is below 7.83 percent, theperson who is long the swap pays $2,527.78.Thus, the nominal value of a basis point for this swap
Change in RatesCash Flows
March 15, 1999June 14, 1999forward periodToday
All gains or losses on aEurodollar contract are paidor collected today. Each basispoint change in the forwardrate is worth $25 for onefutures contract.The settlement value of the swap,which is paid or received at this point,is
(X-F) x (Days/360) x (Notional Principal Amount)
where X is the fixed rate at which theswap was struck originally and F is thefloating rate at the beginning of theforward period.
Exhibit 2Cash Consequences of a Change in a Forward Rate
A change today in the forward interest ratecovering this forward period has two cashconsequences. The P/L from a change in the priceof the corresponding Eurodollar contract would berealized today. The effect on the value of an interestrate swap would be realized at the end of the entireperiod.
is $2,527.78, with the cash changing hands five years in thefuture.
 Eurodollar futures
The futures market has based much of its success on asingle operating principle. That is, all gains and losses mustbe settled up at the end of the day—in cash. This is as trueof Eurodollar futures as it is of any futures contract.Consider the March 1999 Eurodollar futures contract.When it expires on March 15, 1999, its final settlementprice will be set equal to 100 less the spot value of 3-monthLIBOR on that day. Before expiration, the Eurodollar fu-tures price will be a function of the rate that the marketexpects. If there were no difference between a futurescontract and a forward contract, and if the market expecteda forward rate of 7.83 percent, for example, the futuresprice would be 92.17 [ = 100.00 - 7.83]. If the marketexpected 7.84, the futures price would be 92.16. That is, a1 basis point increase in value of the forward rate producesa 1-tick decrease in the futures price.Under the Chicago Mercantile Exchange’s rules, eachtick or .01 in the price of a Eurodollar futures contract isworth $25. This is true whether the futures contract expiresten weeks from now, ten months from now, or ten yearsfrom now. The nominal value of a basis point change in theunderlying interest rate is always $25.
 Reconciling the difference in cash flow dates
We now have two cash payments that are tied to thesame change in interest rates. For the particular forwardswap in our example, a 1-basis-point change in the ex-pected value of 3-month LIBOR for the period from March15 to June 14, 1999 changes the expected value of the swapsettlement on June 14 by $2,527.78. At the same time, a 1-basis-point change in the same rate produces a $25 gain orloss that the holder of a Eurodollar futures contract mustsettle today. The difference in timing is illustrated in Ex-hibit 2.The simplest way to reconcile the timing difference isto cast the two amounts of money in terms of present values.Eurodollar futures are easy to handle. Because gains andlosses are settled every day in the futures market, thepresent value of the $25 basis point value on a Eurodollarfutures contract is always $25.The present value of the $2,527.78 basis point valuefor the swap can be determined using the set of futures ratesprovided by a full strip of Eurodollar futures. For example,if we suppose that $1 could be invested on June 13, 1994 atthe sequence of rates shown in Exhibit 1 — for example,4.56% for the first 98 days, 5.16% for the next 91 days andso on — the total value of the investment would grow to$1.41509 by June 14, 1999. Put differently, the presentvalue in June 1994 of $1 to be received in June 1999 would
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