Essence Investments, a hedge fund, has invested in a USD 1 million mortgage port

Question

Essence Investments, a hedge fund, has invested in a USD 1 million mortgage portfolio earning an average interest of LIBOR +3%. Its internal research has indicated that interest rates are going to drop substantially. It wants to lock in the high interest it has been receiving by using Eurodollar futures contract [notional principal = USD 1,000,000]. Eurodollar futures for 3 months from now settled at 94.88.

a) Essence Investments should take a _____ position on the Eurodollar futures

b) If the actual floating interest rate 3 months from now is 4%, what did the company gain or lose (given the position in part a above)?

Explanation / Answer

a. Long. As the company is expecting a decrease in interest rates, the company should enter a long futures contract which is profited as a result of decrease in interrest rates.

b. + USD 2,800

step 1: Calculate offered annualized rate of return:

3 months Eurodollar futures with a 94.88 price implies an annualized return of 5.12% (100-94.88) for 3 months period.

Step 2: Calculate profit/ loss:

If the company had not entered the futures contract, the interest received would have been = (LIBOR+3%)*3/12*NP = (0.04+0.03)*3/12*1,000,000 = $17,500

Similarly, amount received from Eurodollar futures = (0.0512+0.03)*3/12*1,000,000 = $20,300

Profit from Futures contract = 20300-17500 = $2,800.

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