Jun 05

Eurodollar futures convexity adjustment – Practice question (Par 4 difficulty)

by David Harper, CFA, FRM, CIPM

FRM |

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Assume:

  • The four (4) year Eurodollar futures price quote = 95 (pretty near to actual)
  • Volatility of the change in short-term interest rate = 2%

Question:

  • If we want to estimate the interest rate for a corresponding forward rate agreement (FRA), why do we apply a convexity adjustment?
  • What is the estimated, corresponding forward rate?

 

(don't peek until you try)

 

 

 

 

 

 

 

 

 

 

 

Answer:

For the calculation, see the EditGrid below.

We adjust because the futures contracts settles daily which makes the futures more volatile than corresponding forwards.

The convexity adjustment (Ho & Lee) is given by:

Adjustment = 1/2*T1*T2* volatility. In this case, adjustment = 0.34%. Since a futures price of 95 implies a (continuously compounded) rate of 5.038%, the forward rate = 5.038% – 0.34% = 4.698%

EditGrid:

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