What Is a Eurostrip?
A eurostrip, short for "eurodollar futures strip," is a type of interest rate derivative that allows the holder to hedge against changes in interest rates. It consists of buying a series of three-month futures contracts known as eurodollars.
Therefore, if the trader wishes to hedge their risk for one year, they would buy four consecutive eurodollar contracts, each lasting for three months.
- Eurostrips are a popular derivative transaction.
- They consist of a series, or "strip," of consecutive eurodollar futures contracts.
- Although they are mainly used to hedge currency risk, eurostrips are also used by traders who wish to speculate on interest rate movements.
Eurostrips are a colloquial name used by derivative traders to refer to a series of transactions involving eurodollar futures contracts. Eurodollars are essentially US. dollar-denominated deposits held at foreign banks or at US banks' overseas branches.
As is so often the case in modern finance, there exists an active derivative market based on these eurodollar deposits. Specifically, ever since 1981, the Chicago Mercantile Exchange (CME) has facilitated trading in eurodollar deposits using cash-settled eurodollar futures contracts. These contracts have as their underlying asset eurodollar deposits with principal values of $1 million and maturity periods of three months. The value of these futures contracts fluctuates based on the three-month U.S. dollar London Interbank Offered Rate (LIBOR). Therefore, traders can use eurodollar futures to hedge against or speculate on changes to interest rates.
Eurostrips are a derivative transaction in which the trader purchases a series of back-to-back eurodollar futures contracts. The length of the chain will vary depending on the trader's intentions. For instance, a trader wishing to hedge or speculate one year into the future would construct a eurostrip based on four eurodollar futures (three months each, 12 months in total), a trader looking six months ahead would buy two futures contracts, and so on.
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.
Although eurostrips are most commonly used to hedge interest rate risks, they can also be used to speculate on LIBOR or on the shape of the interest rate term structure.
Real World Example of a Eurostrip
To illustrate, suppose you operate a global investment bank based in Paris, which holds U.S. dollar deposits in its European branches. You are unsure about the future direction of interest rates and are therefore eager to hedge against the foreign exchange risk associated with these dollar holdings.
To hedge against this risk, you create a eurostrip position by taking a long position in four consecutive eurodollar futures contracts. Because each contract lasts for three months, this eurostrip position effectively hedges your interest rate exposure for one year.