How Convexity Adjustment Affects Eurodollar Futures Pricing

Summary

The document raises the difference between a Eurodollar futures implied three-month rate and a forward rate inferred from the yield curve. It identifies convexity adjustment as a possible explanation and asks how to calculate its size without relying on observed market prices. An illustrative example contrasts a futures-implied rate of 2% with a curve forward rate of 1.8%, alongside a current three-month rate of 1.5%.

The text frames a pricing question rather than supplying a model, derivation, or empirical analysis. It does not specify assumptions about interest-rate dynamics, volatility, or the timing of settlement, so it cannot establish a formula or explain why the difference has that magnitude. Its main lesson is that futures and forward rates may diverge because of convexity effects, while quantifying the adjustment requires further modeling inputs absent here.

Key ideas

• Eurodollar futures imply a three-month rate calculated as 100 minus the futures price.
• The document compares the implied rate with a forward rate derived from the yield curve.
• It proposes convexity adjustment as an explanation for the difference between those rates.
• The example illustrates a gap but does not provide a formula or inputs to calculate it.

Tags

# Pricing eurodollar futures


# Pricing eurodollar futures












How are Eurodollar futures priced in practice?

What I already know: The implied 3 Months rate by the futures is 100-price, since it matches the payoff. Using daily LIBOR rates, one should be able to estimate the forward rate between $T$ and $T + 3Months$, where $T$ is the expiration of the nearest Eurodollar futures.

At first I assumed that the Eurodollar implied rate should be very close to forward rate, which is not. I have find something about convexity adjustments, however I am not able to get a formula which would be even a remote approximation of real market price.

Edit: Adding example. Suppose that closing price of ED futures is 98.00, thus the 3M implied rate is 2%. Whereas current 3M rate is 1.5% and 3M forward rate implied from the yield curve is at 1.8%. Thus the 0.2% difference in pricing is the adjustment by convexity bias. My question is, how to calculate the convexity bias without looking at market data. Is there any reason, why it is 0.2% and not, let's say, 0.5%?

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.