question eurodollar futures

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CFAdetroit

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I am drawing a blank on this concept, maybe its the wording. Can anyone break this down a different way so maybe I’ll get it? thanks in advance.
“Eurodollar futures are priced as a discount yield, and LIBOR-based deposits are priced as an add-on yield. The result is that the deposit value is not perfectly hedged by the Eurodollar contract, so Eurodollar futures can’t be priced using the standard no-arbitrage framework.”
 
Right- Eurodollar futures have no convexity and a LIBOR based loan (bond) has convexity. Something with no convexity can’t be a perfect static hedge for something with convexity.
 
From how I understand it, Eurodollar futures are priced like Treasury futures i.e. as a discount yield whereas LIBOR-based loans don’t have a discount yield like a zero coupon bond for example but an add-on yield. CFAI texts explain this by saying that when you try to hedge a Eurodollar future with a LIBOR based loan using no-arbitrage, we are left with a term in the no-arbitrage equation that cannot be determined at the present time (the term is the LIBOR rate at some time in the future) and hence the result. Hope that helps.
 
I don’t know about that, but it’s really easier to think about this in terms of convexity. Eurodollar futures are worth $25/tick at any level. If LIBOR rates are 5% and then settle at 5.01% you get $25/contract and if they go from 20% to 20.01% you get $25/contract. On the other hand, if I have a 90-day LIBOR based loan coming up in 30 days and interest rates change increase by 2%, I’m paying 2% more for that loan but since I’m paying it back in 120 days (key distinction there) I discount that back by some interest rate 2% than before which is some comfort for getting pillaged by the increased interest rate. That gives me convexity.
 
I know Joey’s right, and I think what adb is saying is right as well, because I remember the CFAI texts addressing it from both of those angles.
 
Probably so, I’m not sure exactly what that other term is that CFAI is talking about.
 
Joey,
I think your answer is definitely more intuitive and helps understand things better than something thats formula based like in the CFAI texts.
-Amit
 
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