Eurodollar futures and FRA quoted at the same rate
Question
A Eurodollar futures contract on six-month rates and an otherwise identical forward rate agreement both imply . Which instrument would you rather hold? Is anything mispriced, and which side of each would you take to exploit it?
Short answer
The futures is mispriced: its rate should be above the forward rate, so sell the futures and pay fixed on the forward. Daily settlement hurts a long Eurodollar futures holder: gains arrive when rates have fallen (reinvested cheaply) and losses when rates have risen (financed dearly). So the fair futures rate exceeds the forward rate (the convexity adjustment). With equal quotes the futures price is too high: short it and offset the rate exposure by agreeing to borrow forward at , capturing the convexity benefit.
Adapted from Crack, Heard on the Street, Q2.25, p.28; question and answer rewritten by SelfMadeQuant.com.
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Open the worked solutionLessons behind this question
- Duration and Convexity: Measuring and Managing Interest Rate Sensitivity
- Jensen's Inequality and Convexity
- Forward and Futures Prices: Cost-of-Carry, Known Income, and Continuous Yields
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