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Trading Eurodollar and Euroyen Interest Rate Differentials
Trading Eurodollar and Euroyen Interest Rate Differentials

The fixed tick value and the matching final settlement dates greatly simplify spreading activity between Eurodollar and Euroyen futures contracts. Consider an example using the following assumptions.

JPY/USD exchange rate: 98.61 (yen per dollar)
Price of June 2001 Euroyen futures: 99.50
Implied 3-month interest rate on yen deposits: 0.50%
Price of June 2001 Eurodollar futures: 94.69
Implied 3-month rate on USD deposits: 5.31%
Spread: 481 basis points, or 4.81%

The spread of 481 basis points indicates that the market believes that 3-month Eurodollar rates will be 481 basis points higher than 3-month Euroyen rates on Monday, June 11, 2001 – the day the final settlement price is determined for both contracts. The common final settlement date means that both contracts cover the same mid-June to mid-September time frame. This makes the spread "clean," despite the difference in last trading days.
The spread value will only change with relative changes in implied interest rates. For instance, interest rates in both the United States and Japan can rise, fall, or remain unchanged. If the interest rates move in the same direction and by the same amount, the value of the spread will not change, regardless of the extent to which the interest rates change.

Another significant factor in trading the Eurodollar and Euroyen spread is determining the appropriate number of each contract to buy or sell. Daily profits and losses for Eurodollar futures are denominated in dollars, while those for Euroyen are denominated in yen. This currency mismatch means that traders may want to insulate the interest rate aspect of the trade from variations in the U.S. dollar/Japanese yen exchange rate. This can be done by taking into account the size of each contract and the current exchange rate, using the following formula:

Number of Euroyen contracts/Number of Eurodollar contracts =
Eurodollar contract size/Euroyen contract size X JPY/USD exchange rate
Number of Euroyen contracts/Number of Eurodollar contracts =
$1,000,000/¥ 100,000,000 X 98.61 = .99

This means that .99 Euroyen futures should be bought/sold for every Eurodollar contract in each spread transacted: for example, 99 Euroyen contracts per 100 Eurodollars. The dynamic element in this equation is, of course, the exchange rate. Therefore the hedge ratio may need to be rebalanced periodically if there are significant changes in the exchange rate.