DEFINITION of Eurostrip
A Eurostrip (or Euro-strip) is a series of consecutive three-month futures contracts based on U.S. dollar-denominated deposits in foreign banks, known as eurodollars. Eurostrips, also called eurofutures strips or eurodollar futures strips, are a type of interest rate derivative and, like swaps, are used to hedge against changes in interest rates. A one-year eurostrip would thus consist of four consecutive contracts, each lasting three months, that together have a duration of one year and thus provide an interest-rate hedge for one year.
The end result of hedging using eurostrips is the same as that of using interest rate swaps, but the two contracts are traded differently and have a different set of cash flows. One choice may be more desirable than another at a given time to meet a specific investment objective, or both may be used together. Eurostrips are popular because of their flexibility to be structured in many different ways to meet a variety of hedging needs.
BREAKING DOWN Eurostrip
A eurostrip, or eurodollar futures strip, is essentially a position in multiple successive three-month eurodollar futures contracts with sequential expiration dates. Eurostrips are most commonly used to hedge interest rates risk associated with a floating rate interest instrument, such as a forward rate agreement (FRA) or a variable swap, but can also be used to speculate on LIBOR or on the shape of the interest rate term structure.
An investor may choose to use a futures strip to lock in, or hedge, a particular interest rate for a specific period of time rather than rolling over their futures contracts repeatedly and re-purchasing another futures contract each time the front month contract expires. Depending on the particular market circumstances, rolling over the initial futures trade repeatedly can lead to higher trading costs, and may even generate negative cash flows if the next futures contract is more expensive than the one that is expiring, a condition known as contango. A futures strip, such as the eurostrip, removes that rollover risk for the period of time that the strip is active.
Example of a Eurostrip
For example, a global investment bank based in Paris has U.S. dollar deposits in its European branches. They are eager to hedge against the foreign interest rate risk associated with those dollar holdings. A eurostrip may be constructed by taking a long position in, say, an October eurodollar futures contract, a November eurodollar futures, and a December eurodollar futures. The combined futures positions would collectively constitute the eurostrip.