Why Eurodollar Futures Rates Differ from Implied LIBOR Forwards

Summary

The document examines why a rate inferred by compounding short-term LIBOR fixings can differ from the rate suggested by a Eurodollar futures quote for a roughly comparable period. It explains that three- and six-month LIBOR reflect unsecured lending for different tenors, so the longer tenor carries greater bank credit exposure. The basis between those rates widened during the financial crisis and remained positive, making simple compounding an unreliable assumption.

The response also cautions that a futures-implied rate is not directly interchangeable with a forward rate. A convexity adjustment and stub-period adjustments are needed, since the cited contract covers a loan period that does not align exactly with the assumed forward interval. Forward rate agreements are presented as more straightforward for this comparison because they do not require the same convexity or stub adjustment. The discussion provides a conceptual explanation and a historical observation, but no detailed adjustment formula or full curve construction method.

Key ideas

• LIBOR rates at different tenors reflect different unsecured lending exposures and can diverge.
• The three-month and six-month rates should not automatically be treated as equivalent through simple compounding.
• A Eurodollar futures-implied rate needs convexity and stub-period adjustments for a forward-rate comparison.
• Forward rate agreements avoid those particular adjustments in the comparison described.
• The response gives a qualitative explanation without a full calculation procedure.

Tags

# Market implied rate


# Market implied rate












Today's 3m usd libor (US0003M) is 0.3625% and 6m usd libor (US0006M) is 0.5484%, so from here, the implied 3m USD libor 3m forward is about 0.73%.

Today's EDU0 quote is 99.71 (implied 0.29% rate).

The above 2 rates are roughly referring the same period, but why are they so diffrent?

## Answer by Bond wiz (score 2)

https://quant.stackexchange.com/a/54524

I'm not sure I'm following 100%, but here is the answer to what I think you are asking:

Your line of thinking was common before the financial crisis. Most people assumed that 6M LIBOR was roughly equal to 3m LIBOR compounded to 6m (using fixing and 3m implied forward), and in fact swap curves were constructed using multiple fixings at the short end.

However, LIBOR is an unsecured lending rate between tier 1 banks, which means a 6m loan has twice the credit risk as a 3m loan. In late 2008, this basis blew out (you can see prior, it was fairly close to zero) and has stayed consistently above 0 since.

Also, you shouldn't use the direct ED implied rates- you need to imply a convexity adjustment. There are also stub adjustments you need to make. EDU0 represents a 3m loan starting on 9/16. That is ~3.5 months from now and not the exact 3m forward rate.

FRAs are more straightforward as they don't need a convexity or stub adjustment. I used them in the plot below, and you can see the basis is more consistently positive vs. using unadjusted ED rates, or compounding the 3m fixing twice which doesn't take curve shape into account.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

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