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I am new to rates and learning the basic products. It seems to me that Eurodollar contracts are similar to zero coupon bonds except that it locks in the interest. So I want to clarify if I am misunderstanding how this works.

My understanding is:

When we buy a ED future, we are effectively lending 1mm. So at Day1, we are giving the cp or clearing house 1mm; and on the maturity date we receive the 1mm+the agreed-upon interest.

A zero coupon with 3 month maturity will effectively be the same except for the fixed interest rate part.

So my question is: why do we have two different products that achieve almost the same effect? Are ED futures settled differently (i.e. no notionals are exchanged like swaps)? What exactly are exchanged between the involved parties in a Eurodollar future, and how is it actually a “futures contract”?

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In general futures contracts are leverage instruments. They never require the investment of principal. They do however require margin: you need to fund your account at a futures exchange so that they have insurance against any losses you incur, as an example this might be 2 days standard volatility. On 1 ED contract for 5bps a day thats probably 10bps margin = 250 USD margin. Margin requirements are updated daily dependent on mark-to-market so if the position moves against you the first day by 5bp you will have to pay 125USD to the exchange to stay 250USD clear, on the other hand if the position moves favourably you could withdraw 125USD. You can close positions whenever the exchange is open.

When you buy a ED future you are speculating that the 3M LIBOR rate for the contract settlement date is lower than currently forecast. I.e. you hope the price of the ED contract will rise. If the contract never moves over its life and expires at the same price you bought it you will accrue no gain or loss (except the loss of interest on the 250USD margin you posted to the exchange).

A zero-coupon bond is completely different. This is a security product and essentially a loan to a counterparty with promise of interest and potential capital loss based on the creditworthiness of the CP. You cannot close the trade (except with agreement of the CP)

Also note that a ED contract has specific dates, e.g the Dec 18 IMM contract settles to 3M LIBOR published on the Monday before the 3rd Wednesday in December 2018 (the IMM date) whereas forward settled bonds (ignoring for a second the rareity of zero-coupon bonds) are very rare, you would not expect to trade today an agreement where you lent 1mm USD on the third wednesday of Dec 2018 for 3M tenor.

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  • $\begingroup$ that's a good explanation, however, I think that the bond part is inaccurate - the risk generated there is credit and not counterparty... bonds have cpty risk only until the settlement of the trade $\endgroup$
    – sen_saven
    Feb 20, 2018 at 9:45
  • $\begingroup$ For clarity, I assumed here that a zero coupon bond was issued to a counterparty and that bond was not tradeable in secondary market. I.e. its really a 3M loan reflecting the underlying principle of 3M Libor. I therefore interchanged 'counterparty' and 'creditworthiness' validly. But, in a more general setting you are right and my answer could have been more clear. Hopefully this comment clears things up. $\endgroup$
    – Attack68 ♦
    Feb 20, 2018 at 10:39
  • $\begingroup$ Thanks for the explanation. Still kind of confused about what exactly is delivered on the maturity date of a ED future. In this case, would I be returned the margin I posted and the price difference? How is this different if I were to trade away in a secondary market? $\endgroup$
    – Astaboom
    Feb 21, 2018 at 12:12
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    $\begingroup$ Futures can only be traded on an exchange (a central depository) so there is no de-centralised secondary market. Once a future settles (i.e. its underlying index is fixed) the position ceases to exists so you get your margin back. Say you bought a contract at day one for 99.00 and on day two the price is 98.95 and on day three it settles (expires) at 99.05 then your cashflows are: Day 1: pay out Z margin, Day 2: Pay out 125 USD mark-to-market losses, Day 3: Receive 250 USD mark-to-market gains and rec Z margin back. Net profit is 125USD from the price rising from 99.00 to 99.05 over 2 days. $\endgroup$
    – Attack68 ♦
    Feb 21, 2018 at 15:04

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