CFA Level 1
Derivatives - Eurodollar Time Deposit Markets
Eurodollar time deposits are part of the huge foreign exchange market. Historically, such deposits were held mostly by European banks and financial institutions, and became known as "Eurodollars". As of April 2006, China holds the largest foreign exchange reserves, much of which are denominated in U.S. currency. Such deposits are now available in many countries worldwide, but they continue to be referred to as "Eurodollars", regardless of the location.
Eurodollar time deposits are U.S. dollars on deposit outside the United States, either with a foreign bank or a subsidiary of a U.S. bank. Eurodollars have two basic characteristics: they are short-term obligations to pay dollars and they are obligations of banking offices located outside the U.S. In principle, there is no hard and fast line between Eurodollars and other dollar-denominated claims. The interest paid for these dollar deposits generally is higher than for funds deposited in U.S. banks because the foreign banks are riskier - they will not be supported or nationalized by the U.S. government upon default. Furthermore, they may pay higher rates of interest because they are not regulated by the U.S. government. They are backed by the full faith and credit of the local domestic bank and are issued by its offshore branch. Eurodollar time deposits are designed for corporate, commercial, institutional and high-net-worth investors who want a short-term, high-yield money market investment. Foreign commercial banks such as the Bank of London and South America, Ltd., merchant banks such as Morgan Grenfell and Co., Ltd., and many of the foreign branches of U.S. commercial banks are engaged in Eurodollar business. Funds placed with these institutions may be owned by anyone- U.S. or foreign residents or citizens, individuals or corporations or governments.
Example: Time Deposits
Time deposits are structured in the following way. A London bank, Bank A, needs to borrow $5 million for 30 days. It gets a quote from another bank, Bank C, for a rate of 6%. If Bank A takes the deal, it will owe Bank C $ 5 million x (1 + 0.06(30/360)) = $5,025,000 in 30 days. Unlike the T-bill market, interest is not deducted from the principal but is added on to the face value just like your own bank loans. This procedure is called add-on interest.
LIBOR or the London Interbank Offer Rate
LIBOR, which stands for London Interbank Offered Rate, is the interest rate paid on interbank deposits in the international money markets (also called the Eurocurrency markets). Because Eurocurrency deposits priced at LIBOR are almost continually traded in highly liquid markets, LIBOR is commonly used as a benchmark for short-term interest rates in setting loan and deposit rates and as the floating rate on an interest rate swap. It's considered one of the most important barometers of the international cost of money, and LIBOR has historically reflected money market rates more accurately than the prime- and Treasury-based indexes.
- Most commonly used in derivative contracts
- Even though it is a loan outside of the U.S., it is still considered the best representative rate on a dollar borrowed by a (non-government) private borrower
- Also includes many branches of banks from outside the U.K.
LIBOR is quoted on a one-month, three-months, six-months or yearly basis. Six-month LIBOR is most commonly quoted for mortgages. Both Fannie Mae and Freddie Mac use LIBOR as an index for the loans they purchase.
Euribor (Euro Interbank Offered Rate) is similar to LIBOR except it uses euros and euro deposits in the lending and borrowing between banks, instead of dollars. Euribor is the rate at which euro interbank term deposits are offered by one prime bank to another prime bank. It is compiled in Frankfurt and published by the European Central Bank. Euribor is the benchmark rate of the large euro money market and is sponsored by the European Banking Federation (FBE), which represents the interests of 4,500 banks in 24 Member States of the European Union and in Iceland, Norway and Switzerland and by the Financial Markets Association (ACI).
The choice of banks quoting for Euribor is based on a number of market criteria, but all banks are selected to ensure that the diversity of the euro money market is adequately reflected, thereby making Euribor an efficient and representative benchmark.
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