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(ProQuest Information and Learning: ... denotes formulae omitted.)
Eurodollar futures are used extensively to hedge conventional LIBOR-based interest rate swaps, yet very little has been written on how to actually perform the hedging. Nor does there appear to be any published empirical documentation of how such hedges might perform.
A LIBOR-based interest rate swap is defined as a plain vanilla interest rate swap whose floating payment is equal to LIBOR of a specific maturity times the swap's outstanding notional principal amount. The floating swap payment is reset at the same frequency as the term of the LlBOR instrument.
Kawaller 1198, 1989, 1994] treats a swap as equivalent to a series of Eurodollar futures strips, and determines Eurodollar futures hedging quantities accordingly. His approach to hedging is fairly straightforward when a swap's interest reset dates align with the maturity dates of Eurodollar futures contracts. When the dates do not align, or when the reset dates occur on a frequency different from the threemonth Eurodollar futures maturity cycle, Kawaller's methodology requires a best guess estimate of the ex post difference between the LIBOR implied by futures prices and actual LIBOR.
Standard Eurodollar futures contracts mature every March, june, September and December for 40 consecutive maturity months. Contracts are also traded that mature in the four most-nearby months not included in the regular maturity cycle, but they tend to be very illiquid compared to contracts in die regular three-month maturity cycle.
The Kawaller methodology does not provide for the use of futures contracts outside the regular three-month maturity cycle, and applies only to the hedging of newly issued swaps.
Burghardt [2003] provides a comprehensive calculus-based approach to Eurodollar futures-based pricing and hedging of swaps. he separates Eurodollar hedging quantities into two components: a component due to the primary effects of potential interest rate changes, and a much smaller component due to secondary effects. It can be shown that the hedging quantities Kawaller ]1994| proposes are equivalent to those associated with Burghardt's primary effects.
Although all Burghardt's examples are based on perfect alignment of futures maturity dates and swap interest reset dates, he suggests that a linear interpolation of cumulative continuously compounded rates implied by the Eurodollar futures curve can be used to deduce cumulative continuous rates and...