Hey Guys,
I m completely messed up on this topic, i m not getting one thing here clearly that…if the underlying (Euro deposits) is quoted at add on rate and the derivative (i.e eurodollar futures contrcts) are quoted at discount…so how they are getting traded in the markets ? can someone plz throw some light behind these two concepts so that i can fix it my head !!
First of all, this has nothing to do with the Euro.
The add on rate that you reference is the LIBOR which is an add on rate (nothing special in this statement really).
Now, the futures contract on the Eurodollar deposits are traded similar to t-bill contracts (i.e., the price quotes are treating the rate as a discount from price).
Look up CME contracts specs (google it) to get more detailed contract specs.
can you please explain me that why it’s not considered to be perfect hedge ?
Because a 1% change in interest rates doesn’t result in the same percentage change in the value of the underlying when it’s an add-on rate and when it’s a discount rate.
That’s not it. 1% change in interest rates do not translate into 1% price change for most contracts (t-bills included) unless the duration of the security is exactly 1 (even then not really). The issue is that due to add-on interest rate, we cannot price the eurodollar futures contract using the cash and carry (no) arbitrage principles.
You misunderstood what I wrote.
A 1% change in interest rates produces one change when you have an add-on rate and a different change when it’s a discount rate.
I believe that this difference leads to the inability to construct a perfect arbitrage transaction; hence, the inability to price eurodollar futures via cash and carry.
it is a comparison between 1/1.01 [Discount rate] and 0.99 (1-0.01) [add on rate]
it is close - but not exactly identical.
That’s what I thought.