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With the globalization of financial markets, the growth of the international capital markets becomes rapidly, especially the Eurocurrency and Eurobond markets. A Eurocurrency is a dollar or other freely convertible currency deposited in a bank outside its country of origin. The prefix Euro as used here has nothing to do with the currency known as the euro or with Europe. Such as, the U.S dollars on deposit in banks outside the United States are called Eurodollar. Eurodollars are not under the jurisdiction of the Federal Reserve. As long as the U.S dollar was the world's main means of international payments, the Eurodollar became the dominant Eurocurrency in the financial market.
The Eurodollar first came about in 1957 because of the cold war. After the Second World War, the quantity of U.S dollars outside the United States increased enormously. As a result, enormous sum of U.S dollars were in the custody of foreign banks outside the United States. During the cold war period, the Soviet Union feared that its deposits in North American banks would be frozen as retaliation. It decided to move some of its holdings to the Moscow Narodny Bank, which is a Soviet owned bank with a British charter. The British bank would then deposit that money in the US bank. There would be no chance of confiscating that money, because it belonged to the British bank and not directly to the Soviets. On February 28, 1957, the sum of $800,000 was transferred, that creating the first Eurodollar. At first the Eurodollar was only in European nations but because of the large commercial deficits of the United States the Eurodollar market quickly expanded worldwide.
The growth of the Eurodollar Market is caused of the restrictive U.S government policies. These policies include reserve requirements on deposits, special charges and taxes, required concessionary loan rates, interest rate ceilings, and rules which restrict bank competition. Such as Regulation Q of the Federal Reserve System, which fixed the rates of interest, paid on time deposits but did not apply to time deposits owned by foreign accounts. Competition among New York banks led returns on such deposits in 1958 and 1959 to rise one-fourth of 1 percent above the Regulation Q ceilings. This induced banks in London to bid for dollar deposits, which they conceded to New York. European lenders and borrowers in dollars also found it convenient to trade in dollars in London rather than New York, because of the identity of the time zones, without the need to limit trading to the few hours a day when Europe and U.S. banks were open simultaneously.
Through the 1960s, the Eurodollar market grew rapidly. Currencies other than dollars were traded outside their domestic markets. London was at the centre of the Eurodollar market at that time. Depositors consist mainly of Europe central banks, firms, and individuals in the United States and in third world countries. In the 1970s, the practice of accepting deposits in U.S. dollars and other non-local currencies spread to banks in Singapore and Hong Kong. As long as the banks outside of the United States offer convenience and smaller spreads than U.S domestic banks. The Eurodollar market continues to thrive.
The most important characteristic of the Eurodollar market is that loans are made on a floating rate basis. The benchmark lending rate for Eurodollar became know as dollar LIBOR (London Interbank Offer Rate). This is also called as the Eurodollar rate, which is a zero coupon dollar benchmark interest rate that is quoted for various period such as overnight, one month, three month, six month and one year. Interest rates on loans to governments and their agencies, corporations and nonprime banks are set at a fixed margin above the LIBOR for the given period and currency chosen. At the end of each period, the interest for the next period is calculated at the same fixed margin over the new LIBOR. Fro example, if the margin is 60 basis points and the current six month LIBOR is 3%, and then the borrower is charged 3.6% for the upcoming period.
Since the late 1980s, the London interbank offered rate has become less important as a benchmark for lending money in the Eurocurrency market, in much the same way that the prime rate is no longer the all-important benchmark in the U.S bank loan market. Although Eurocurrency rates are still computed off LIBOR, a number of creditworthy borrowers (such as Denmark, Sweden, several major corporations, and some banks) are obtaining financing in the Eurocurrency markets at interest rates well below LIBOR. For example, high-quality borrowers at the London interbank bid (LIBID) rate, which the rate paid by one bank to another for a deposit. LIBID is about 12.5 basis points below LIBOR. The high-quality borrowers, such as the World Bank, can raise funds at below LIBID. This trend largely reflects the fact that the ability of banks to impose themselves as the credit yardstick by which all other international borrowers are measured had faltered.
The LIBOR also used as a reference rate for Eurodollar contracts. The Eurodollar futures contracts are traded at the Chicago Mercantile Exchange (CME) in Chicago. They are the world's most heavily traded short term interest rate futures contracts and extend up to ten years. Each CME Eurodollar futures contract has a face value of $1,000,000. Though the leverage used in futures allows one contract to be traded with a margin of about $1,000. The CME's Eurodollar futures contracts are based on three month U.S dollar LIBOR rates. The price of a Eurodollar futures contract is defined to be 100.00 minus the three month LIBOR on the contract settlement date. For example, an anticipated annualized interest rate of 5% will translate to a futures price of 95.00. On the expiry day of the contract, the contract is valued using the current fixing of three month LIBOR.
From the example we can see at the expiration, if the interest rate raises 1%, the value of the futures contract will be quoted at 94.00. The buyer will compensate the seller $2,500 for one of $1,000,000 valued contract, and vice-versa. Thus the appropriate hedging position can be used to deliver a cash flow that compensates the hedger for the change in interest rates that occurs between the trade date and the settlement date. However, since futures contracts are marked to market daily by the clearing house of the exchange these transfers actually occur incrementally through the period between the trade date and the delivery date and not just on the delivery date.
From the principle of how the Eurodollar futures contract works, we can find out if the yield raises the price of the futures contract will falls and vice-versa. Therefore, if you believe that interest rate will fall, you would then buy a CME Eurodollar futures contract because you expect the contract price to rise. And vice-versa, if you believe rate will rise, you would sell or short-sell a CME Eurodollar futures contract because you expect the contract price to fall. This retains the normal inverse relationship between the price and the yield of interest rate securities. However, the bond convexity is not maintained due to the pricing of the Eurodollar contracts in yield terms.
In recent years, the global economic is in recession. There is so much uncertainty in today's financial market. Therefore, it is important for investors to properly analyze, not only market environment, but also their investment goals. Especially invest in currency market, that always with large potential risk.