Writers incorporate the models of Hirshleifer (1988) and Longstaff and Schwartz (1992) to allow for the effects of factors which affect both spot and futures risk premia, modeling the risk premium as a function of the net hedging pressure, as well as the level and volatility of the underlying spot rate.
Transcript
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Risk premia in EuroDollar futures prices Beni Lauterbach & Margaret Monroe Smoller Bar Ilan University, 52100 Ramat-Gan, Israel and Wayne State University, Detroit, MI 48202, USA Team Member: Yang Liu
The return in excess of the risk-free rate of return that an investment is expected to yield.
An asset's risk premium is a form of compensation for investors who tolerate the extra risk - compared to that of a risk-free asset - in a given investment.
Eurodollars :
U.S.-dollar denominated deposits at foreign banks or foreign branches of American banks. By locating outside of the United States, eurodollars escape regulation by the Federal Reserve Board.
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Something about Eurodollar futures contract and the market
When?
The market for Eurodollars, which are US dollars on deposit outside the United States, has been in existence since the early 1950s.
One of the most widely traded!!
Why?
The increased use of this contract is partly due to its acceptance as the main instrument for hedging short-term interest rate risk by US hedgers (Szymczak, 1988), and non US hedgers (Sherman,1989).
Provide additional evidence on the existence and reasons for Eurodollar futures risk premia.
Writers incorporate the models of Hirshleifer (1988) and Longstaff and Schwartz (1992) to allow for the effects of factors which affect both spot and futures risk premia, modeling the risk premium as a function of the net hedging pressure, as well as the level and volatility of the underlying spot rate.
the premia in part to the marking to market feature, which causes futures prices to diverge from forward prices.
2. Bessembinder(1992)
Eurodollar futures mean returns are positive and larger conditional on short hedging than those conditional on long hedging.
Further, measures of unconditional betas in this martket to be small : single factor beta is 0.006, which indicates that prices exhibit a risk premium, but with conflicting reasons for its existence.
Using Wednesday closing prices of all Eurodollar futures contracts traded on CME from January 5 th ,1983 to December 27 th ,1989, and the corresponding weekly LIBOR rates, obtained from the CME annual yearbooks of IMM data.
Special , the writer omit the 1982:
To avoid any short-term anomalies caused by traders’ lack of familiarity with the new contract.
2. The Eurodollar Future price is a function of the expected LIBOR rate at the contract maturity and the total expected risk premium . The futures price at time t is written as
We can calculate the total expected premium for the (T-t) weeks, from Equation 2.Assuming rational expectation that the expected LIBOR change Equal to 0, allowing us to use the current LIBOR rate instead of the expected rate.
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The mean per-week expected premia on contract X is estimated as LIBOR is the 3-month LIBOR rate, F X ,t is closing price of contract X, and TTM X is the number of weeks to maturity of contract X. The per week percentage point expected premium on contract X is computed as
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