I’m having diffculty understanding the following and could someone help enlighten? Thanks in advance!
Why is it there is difficulty in pricing Eurodollars just because it is an add-on instrument (eg add on with LIBOR). Don’t other instruments also use LIBOR?
Because it’s an add-on rate, the discount rate isn’t known until the expiration of the futures contract.
The pure arbitrage relationship would not hold between a T-Bill (pure discount instrument) and a Eurodollar Futures contract (add on yield).
The simple way to think of this is that you would buy a T-Bill future at say $99 and then it gets delivered to you at expiry for $100 thus your return comes from the fact that you bought it at a discount.
With a Eurodollar future you are contracting to lend/borrow at a time in the future. Therefore at expiry you give someone/borrow $100 and pay/recieve the current rate - and say at expiry you would owe/recieve $101.
There is no way to constuct an arbitrage transactions between these. Very quirky for sure.