Eurodollar futures
- Thread starter Ened
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It's called a convexity adjustment. Re math, see Hull's attached technical note.
Re intuition, it's the difference between a futures contract (settled daily) and a forward contract (FRA) which tends to matter only for longer maturities: as a futures settles daily, it benefits/hurts from interest rate volatility on the upside, which a forward does not; i.e., if rates go up, daily settlement leads to sooner cash flow. That is the 'daily settlement' factor which leads to a difference. There is a 2nd factor which frankly escapes me...
Do you have Hull 6th Ed, his chapter 6 has a discussion.
David
Re intuition, it's the difference between a futures contract (settled daily) and a forward contract (FRA) which tends to matter only for longer maturities: as a futures settles daily, it benefits/hurts from interest rate volatility on the upside, which a forward does not; i.e., if rates go up, daily settlement leads to sooner cash flow. That is the 'daily settlement' factor which leads to a difference. There is a 2nd factor which frankly escapes me...
Do you have Hull 6th Ed, his chapter 6 has a discussion.
David
Ened,
That math on this is hard, IMO. And, this is not the only way to adjust for the difference, there are other models. On the intuition as to why there is a difference, if you hold the futures contract, the Eurodollar futures, daily settlement impacts your margin (on the upside, you may withdraw excess margin). But the forward, as an OTC, typically does not settle daily. So, your futures contract, other things being equal is risker for the volatility. Riskier for the mark-to-mark inspired volatility = higher rate.
on that 2nd component into convexity adjustment, it was bugging me, so i reread the Hull in chapter 6. And i'm frankly a bit confused by it. In the Hull model, it looks like (really) one cause for the difference, i.e., daily settlement (admittedly he has two causes, the but the 2nd is trivial), but as think about it, the other difference ought to relate to default risk (a OTC forward has counterparty risk that a clearinghouse does not give), so perhaps there are other 'convexity bias' models that account for the default risk. In other words, i am not clear why Hull's eq. does not account from both daily settlement & counterparty risk....
David
That math on this is hard, IMO. And, this is not the only way to adjust for the difference, there are other models. On the intuition as to why there is a difference, if you hold the futures contract, the Eurodollar futures, daily settlement impacts your margin (on the upside, you may withdraw excess margin). But the forward, as an OTC, typically does not settle daily. So, your futures contract, other things being equal is risker for the volatility. Riskier for the mark-to-mark inspired volatility = higher rate.
on that 2nd component into convexity adjustment, it was bugging me, so i reread the Hull in chapter 6. And i'm frankly a bit confused by it. In the Hull model, it looks like (really) one cause for the difference, i.e., daily settlement (admittedly he has two causes, the but the 2nd is trivial), but as think about it, the other difference ought to relate to default risk (a OTC forward has counterparty risk that a clearinghouse does not give), so perhaps there are other 'convexity bias' models that account for the default risk. In other words, i am not clear why Hull's eq. does not account from both daily settlement & counterparty risk....
David
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