In an earlier lesson, I described how to use the federal funds futures contract to forecast changes in the federal funds interest rate, the most powerful weapon in the Federal Reserve's monetary arsenal. The contract works well for assessing market expectations for near-term changes in this key interest rate. But for handicapping rates months into the future, professionals look to eurodollar futures.

If you haven't done so already, check out my lesson Forecasting The Fed With Fed Funds Futures. In summary, the fed funds rate set by the Federal Open Market Committee determines the overnight lending rate that banks charge each other for loans of excess reserves. Lowering the rate stimulates bank lending and, thus, economic activity -- raising the rate accomplishes the opposite.

When trying to get a handle on the probable rate-setting outcome of an upcoming FOMC, one uses the fed funds futures contract. However, open interest and volume in the fed funds contracts fall to meager levels for contracts expiring in the months further out. This makes pricing too volatile to render statistically reliable forecast data.

Eurodollar contracts, however, have ample open interest. In fact, eurodollar futures are the most actively traded contracts in the world. At the time I'm writing this lesson, there are 3.3 million eurodollar contracts outstanding vs. 45,400 fed funds contracts. Thanks to this enormous liquidity, we can trust that the daily settlement prices in eurodollar contracts accurately reflect the market's assumptions about the future level of the fed funds rate.

Eurodollars are U.S. currency held in non-U.S. banks, European or otherwise. For example, U.S. dollars deposited in a Hong Kong bank are eurodollars. Thanks to the dollar's status as the world reserve currency, eurodollars are commonly used to settle international transactions.

When you want to forecast the likely fed funds rate that will prevail after the next FOMC meeting, you calculate the implied yield of the fed funds futures contract for that or the following month (depending on factors detailed in my previous lesson). When you want to forecast the fed funds rate for some time many months in the future, you look at an adjusted implied yield of the eurodollar contract for that point in time.

There's a fed funds contract for every month in the year. In other words, the September fed funds contract represents the market's best guess at the prevailing fed funds rate for that month. Eurodollar contracts span quarters, except for near-term months, which also have open contracts. So the adjusted implied yield of the December eurodollar contract would represent the market's consensus forecast for the fed funds rate in the month that the contract expires. 

The ticker symbol for the eurodollar contract is ED, followed by the letter designating the expiration month of the contract and the number designating the contract year. March is represented by the letter H, June by M, September by U and December by Z. The year symbol is simply the last digit of the year. For instance, the year 2001 would be 1. So the March 2001 contract would have the ticker EDH1.

Adjusting The Implied Yield

Okay, I've said that we must adjust the implied yield of the eurodollar contract in order to divine the market's fed funds rate consensus for the contract quarter. What are we adjusting for? Loans of foreign-deposited dollars carry a higher interest rate than loans of dollars deposited in U.S. banks. We need to factor out this premium to get at the implied yield reflecting the fed funds rate assumption priced into the contract. 

To do so, we turn to the London Interbank Offered Rate, better known as LIBOR. The LIBOR represents the rate that creditworthy international banks charge each other for loans of eurodollars. The spread between the three-month LIBOR and fed funds rate represents the premium that we want to subtract from the implied yield of the eurodollar contract.

Let's say that the LIBOR stands at 6.66%, a spread of 16 basis points above the fed funds rate of 6.50% at the time I'm writing this lesson. We're interested the market's assessment of where the fed funds interest rate will stand in the quarter ending March 2001. Assume that the March 2001 eurodollar contract settled at 93.33. That gives an implied yield of 6.67% (100 - 93.33). Now subtract the LIBOR-fed funds spread of 16 basis points. This adjusts the implied yield to 6.51%. So the market is pricing in only one basis point of tightening. In other words, the market assumes a very high probability that the Federal Reserve will not raise rates between now and March 2001.

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