Eurodollar
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Eurodollars are deposits denominated in United States dollars at banks outside the United States, and thus are not under the jurisdiction of the Federal Reserve. Consequently, such deposits are subject to much less regulation than similar deposits within the United States, allowing for higher margins.
The first transaction involving such deposits was initiated by a bank owned by the Soviet Union, which sometimes used the telex address "Eurbank". Initially dubbed "Eurbank dollars", they eventually became known as "eurodollars".[1] The latter name became widespread because such deposits were held mostly by European banks and financial institutions. Such deposits are now available in many countries worldwide, but they continue to be referred to as "eurodollars" regardless of the location.
The term "eurodollar" should not be confused with the joint European currency, the euro.
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[edit] History
Gradually, after the Second World War, the amount of U.S. dollars outside the United States increased enormously, both as a result of the Marshall Plan and as a result of imports into the U.S., which had become the largest consuming market after peace was reestablished in Europe.
As a result, enormous sums of U.S. dollars were in custody of foreign banks outside the United States. Some foreign countries, including the Soviet Union, also had deposits in U.S. dollars in American banks, granted by certificates.
During the Cold War period, especially after the invasion of Hungary in 1956, the Soviet Union feared that its deposits in North American banks would be frozen as a retaliation. It decided to move some of its holdings to the Moscow Narodny Bank, a Soviet-owned bank with a British charter. The British bank would then deposit that money in the US banks. There would be no chance of confiscating that money, because it belonged to the British bank and not directly to the Soviets. On February 28, 1957, the sum of $800,000 was transferred, creating the first eurodollars.[1]
Gradually, as a result of the successive commercial deficits of the United States, the eurodollar market expanded worldwide.
[edit] Eurodollar Futures Contract
At the same time, eurodollar refers to the financial futures contract based upon these deposits. Traded at the Chicago Mercantile Exchange (CME) in Chicago, each CME Eurodollar futures contract has a notional or 'face value' of $1,000,000, though the leverage used in futures allows one to trade a contract for just hundreds of dollars. Trade in Eurodollar futures is extensive, thus offering uniquely deep liquidity. A purchase or sale is, in effect, a bet on U.S. short-term interest rates. Prices are quite responsive to Fed policy, inflation, and other economic indicators.
CME Eurodollar futures prices are determined by the market’s forecast of the 3-month London Inter Bank Offered Rate (LIBOR). The futures prices are derived by subtracting that implied interest rate (yield) from 100.00. For instance, an anticipated interest rate of 5.00 percent will translate to a futures price of 95.00 (100.00 – 5.00 = 95.00). Given this price construction, if interest rates rise, the price of the futures contract falls, and vice versa. This retains the expected relationship between the price of an interest rate based contract and the yield of the same contract
If you believe that interest rates will fall, you would then buy a CME Eurodollar futures contract (and vice versa; if you believe rates will rise, you would sell a CME Eurodollar futures contract).
Prices of CME Eurodollar futures trade in increments of one-quarter and one-half of one basis point, depending upon when the contract expires, and this is often referred to as the “tick” value. Gains or losses are calculated simply by determining the number of ticks moved, multiplied by the value of the tick.
A full tick or basis point in CME Eurodollar futures, for example, is worth $25.00. The $25.00 basis point value is based on the $1,000,000 notional value of this contract, as calculated below:
$1,000,000 notional value x .0001 (one basis point) x 90/360 (three month) deposit period = $25.00
For the nearest expiring or “spot” month in CME Eurodollar futures (serial or quarterly), the minimum price fluctuation is 1⁄4 of a basis point or a “1⁄4 tick,” which is $6.25. For all other CME Eurodollar contracts, the minimum price fluctuation is 1⁄2 of one basis point, or a “1⁄2 tick,” which is $12.50.
The CME Eurodollar futures contract is used to hedge interest rate swaps. There is an arbitrage relationship between the interest rate swap market, the Forward Rate Agreement market and the Eurodollar contract. CME Eurodollar futures can be traded by implementing a spread strategy among multiple contracts to take advantage of movements in the forward curve for future pricing of interest rates.
The front month contracts are among the most liquid futures contracts in the world. The contract suite has quarterly expirations out to 10 years. Each year has a reference color, with the first year from today being referred to as 'front' months.
[edit] Eurodollar sweeps
In United States Banking, eurodollars are a popular option for what are known as "sweeps". By law, banks aren't allowed to pay interest on corporate checking accounts. To accommodate larger businesses, banks may automatically transfer, or sweep, funds from a corporation's checking account into an overnight investment option to effectively earn interest on those funds. Banks usually allow these funds to be swept either into money market mutual funds, or alternately they may be used for bank funding by transferring to an offshore branch of a bank (thus a eurodollar).
[edit] Finance
In finance, the prefix "euro" as in "eurodollars" or "euroyen" refer to currency deposited outside the country of their origin.
Eurodollars are time deposits denominated in United States dollars at banks headquartered outside the United States, or in foreign branches of banks headquartered within the United States. There is nothing "European" about Eurodollar deposits; a US dollar-denominated deposit in Tokyo or Caracas would likewise be deemed Eurodollar deposits. Such deposits are normally in excess of $1,000,000, and typically (although not exclusively) involve deposits placed by one financial institution with another financial institution. As such, the Eurodollar rate is reflective of a large bank's cost of funds. Trading is extensive and quite active, particularly in maturities ranging from one day to six months; there is some very light trading that may run out as far as five years.
Although paid on deposits booked elsewhere in the world, the Eurodollar rate is driven primarily by the American economy (because it represents an interest rate paid on US dollar-denominated deposits). By and large, when the Fed tightens (or is expected to tighten within the lifetime of the deposit) the Eurodollar rate goes up, and when the Fed eases (or is expected to ease) the Eurodollar rate goes down.
In addition, the interest rate on Eurodollar deposits can and does vary throughout the day in response to supply and demand. This can be problematic for market participants who seek to use Eurodollar rates as benchmarks. The LIBOR rate and other similar rates were therefore developed for that purpose, representing a snapshot of the Eurodollar market in a specific locality and point in time (11:00 a.m. in London in the case of LIBOR).
Eurodollar rates should not be confused with the currency called the euro, which is the common currency of some members of the European Union. Prior to the introduction of this currency, traders in Eurodollars would colloquially refer to them as "Euros", but this practice has diminished since 2002.
The market for Eurodollar futures has grown to be highly liquid with the introduction of online trading(Globex).
[edit] See also
- Swaps
- Forward Rate Agreement
- LIBOR
- TED spread
- Eurocurrency
- Petroeuro
- Eurozone
- Currencies related to the euro
- The eurodollar is also a fictional currency used worldwide in the setting of Cyberpunk 2020
[edit] Notes
- ^ a b "Adam Smith", Paper Money, London: Macdonald & Co, 1982, p. 122
[edit] Bibliography
- RATTI, B. Comércio Internacional e Câmbio. 9ª Edição. São Paulo, Brazil, Edições Aduaneiras, 1997
- SANDRONI, P. Novíssimo Dicionário de Economia. 5ª Edição. São Paulo, Editora Best Seller, 2000.
