Articles, Medill Reports

Published by Medill Reports

By Shera Balgobin, Regan E. Doherty and Christina Maria Paschyn
March 6, 2007

The future looks rosy for the Eurodollar, and Chicago Mercantile Exchange Holdings Inc. is banking on it. It is expected to be the number one contract on the merged exchange.

Despite the Dow’s plunge, CME Eurodollar futures traded a record 4,962,178 contracts on Feb. 27, when the stock market tanked, eclipsing the previous benchmark set in September 2005.

“I’ve never seen anything like it in my life,” said Leonard Kardelis, a local Eurodollar trader. “We rallied through the moon.”

Already the world’s most actively traded futures contract, Tuesday’s results confirm the Eurodollar’s prominence at the Merc and in the greater global marketplace.

“It was crazy,” said independent trader Patrick Lynch. “Eurodollars were two to three ticks higher.”  When the Dow dropped 200 points, Eurodollars moved inversely and jumped another 12 ticks.

Lynch sees this as a flight to quality by investors seeking a safe haven for money:

“That’s $625 on a single contract.  Big hedge funds could have 5 or 10,000 [contracts]. You do the math—it’s big money.”

Eurodollar futures help investors to hedge interest rate fluctuations on Eurodollars, which are U.S. dollars deposited in commercial banks outside the United States, either at foreign banks or foreign branches of American banks.  On average more than 3 million CME Eurodollar futures contracts trade daily.

As the CME prepares to merge with the CBOT Holdings Inc, owner of the Chicago Board of Trade, Eurodollar futures trading continues to grow.

“The Eurodollar future builds off the larger basket of products, because it meets a need of the industry,” said Robin Ross, managing director of interest rate products at the CME. “These markets continue to grow exponentially.”

Interest rate products, particularly Eurodollar futures and options, represent the single largest segment of growth at the Merc, comprising more than half of the exchange’s daily volume and trading more than $500 trillion annually in notional value.

“The banking industry loves Eurodollar futures because they allow banks to hedge with almost surgical precision,” said Galen Burghardt, author of The Eurodollar Futures and Options Handbook and an adjunct professor at the University of Chicago Graduate School of Business. “One of the main challenges banks face is that of managing interest rate exposure. Rate exposure can be very complex, but Eurodollar futures allow it to be simplified.”

For this reason, banks primarily use the contracts to hedge not only their short term interest rate risks, but also their floating rate risk three to four, even ten, years out, Ross said.

The Eurodollar market also is relatively free of regulation, enabling banks to operate on narrower margins than banks in the United States.  Many believe that the Eurodollar market has expanded as a means of avoiding these regulatory costs.

The three month interest rate on a U.S. dollar deposited overseas is “a very static relationship, much higher than the federal funds rate, and that’s why this is such a popular contract,” according to Lynch.

Banking rules differ in the Euromarket from those in the U.S. market.  In the Euromarket, all deposits, with the exception of call money, have a fixed maturity that can range from one day to five years.

Interest is paid on all deposits, with the rate determined by market conditions.  No reserve requirements and no FDIC premiums are imposed on Eurodollar deposits. The Euromarket operates outside the control of any central bank.

The sources of Eurodollar deposits include large corporations—foreign, domestic and multinational—central banks, other government bodies, and wealthy private investors.

Burghardt doubts that the CBOT/CME merger will impact Eurodollar futures trading significantly. “The merger itself won’t matter much, unless it causes the combined exchange to make the Treasury futures contracts more competitive than they are now, which is highly unlikely.”

However, he indicated that a decrease in the price of Treasury contracts may result in increased trading overall.  “If some reason they decide to make Treasury contracts cheaper, it may just result in more trading of everything.”

Burghardt recognizes that Eurodollar trading has gotten more and more active over the past 10 years and believes the trend will continue.

“Trading was up 22 percent last year and there was no extra volatility to explain it,” he said.  “It’s just a growing market.”

Analyst Patrick O’Shaughnessy of Morningstar Inc. concurs.  “I think that the current demand for trading Eurodollars will not decrease,” he said, noting the contracts’ importance to the Merc.  “They represented about 57 percent of CME’s 2006 revenue, so a serious decrease in the popularity of trading those products would negatively affect their bottom line.”

He believes that no new product is likely to surpass Eurodollar trading in the near future.

In recent years online trading has exploded, and now more than 85 percent of CME Eurodollar futures trade electronically on the CME Globex platform.  “It’s done nothing but good things, making the Eurodollar more liquid and cheaper,” Burghardt said.

Not surprisingly, the CME has expanded its Eurodollar futures and options offerings, allowing investors to trade in packs, bundles and five-year e-mini bundles.

CME Eurodollar futures celebrated their 25th anniversary last December. When launched in 1981, they were the first cash-settled futures contract.  Until that point, final settlement of futures positions required physical delivery of the commodity.

“The Merc was innovative starting that contract,” Lynch said.  “A lot of people laughed at it saying there is not a need for it—how wrong they were!”

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