Sep 03

Convexity adjustment for Eurodollar futures and FRA – 5 min screencast

by David Harper, CFA, FRM, CIPM

FRM |

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Here is a brief walk-through of the convexity adjustment as it is used to compare a Eurodollar futures contract with a similar forward rate agreement (FRA). Please do not confuse with bond convexity. Key ideas for FRM candidate:

  • A key difference between a futures contract and a forward contract is daily settlement: the instrument is daily marked-to-market. If the value of the futures increases, this creates excess margin cash; if value declines, there will be a margin call (when the maintenance level is reached).
  • Therefore, a Eurodollar futures contract has more volatility than a similar forward rate agreement (FRA). This implies a slightly higher rate.
  • The difference is not meaningful over short periods. Over longer maturities, the difference does matter.
  • We can use different approximations. The FRM assigned reading is Hull; he uses the Ho and Lee approximation:

ed_convexity_adj

Screencast:

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