An analysis of T-Bill and eurodollar futures as hedging instruments for loans based on prevailing T-Bill and CD rates

Abstract

The purpose of this study was to determine the effectiveness of two different interest rate futures instruments in hedging interest rate changes in short-term loans. In this case, the hedge ratio was obtained by using the empirical method of regressing changes in the price of the spot instrument against changes in the price of the futures. The interest rates on each of the short term loans to be hedged were based on the prevailing 90-day T-Bill or CD rates. The terms of the loans were one month or three months. The hedging instruments used were T-Bill futures and Eurodollar futures contracts. This resulted in eight different types of hedges. Three methods were used to compare and assess the perfonnance of the various hedging instruments: the Standard Distance from Optimal Method, the Percentage Hedged Classification Method, and the Variation/Percentage Hedged Matrix. The Standard Distance from Optimal Method measures the average number of basis points that the hedging instrument leaves exposed in the 35-month period. The Percentage Hedged Classification Method assigns points to a hedge by classifying its perfonnance as Good, Satisfactory, Marginal or Unsatisfactory. The Variation/Percentage Hedged Matrix takes the results from the Percentage Hedged Classification method and relates them to the variability of the cash instrument. Given these means of evaluation, its was deternlined that the optimal hedging strategy with the studied hedging and cash instrumenls is as follows.

Type of Loan Hedging Instrument*

One-Month T-Bill-Based Loan..........T-Bill, 1 month Three-Month T-Bill-Based Loan........Eurodollar, 3 months One-Month CD-Based Loan..............Eurodollar, 3 months Three-Month CD-Based Loan............Eurodollar, 3 months

*Futures contract, minimum period until maturity.

The results of this study indicate that further research is warranted to investigate the relatively higher performance of longer-term hedging instruments with short-term loans.