Convexity Adjustment in Eurodollar Futures.

[Arka Bose]

In Hull Interest rate futures, he shows that future rates are higher than forwards due to interim cash flows and thus there is a convexity adjustment for futures and forwards.

However, I was thinking like this, the LIBOR rate is negatively correlated with that of the Eurodollar futures. In that case, shouldnt the futures be lower priced in the market than the forwards?

 

[ShaktiRathore]

Hi
Libor rate has nothing to do with convexity adjustment apart from determining payoff of eurodollar futures,in fact what we are adjusting for in value is the interest rate at which profits from futures can be invested at because in futures profits can be received well before than in forwards and can invest in interest rate increases their value relative to forwards thus the convexity adjustment. We are not adjusting value relative to Libor but relative to interest rates.We have already taken into account the lowering of libor in the payoff of eurodollar futures taking its effect again in convexity adjustment double counts it rather we take the adjustment separately on the value of futures.

 

[Arka Bose]

I am confused, libor rate is an interest rate, so in that case, interest rate and the futures are negatively correlated?

 

[ShaktiRathore]

please dont get confused if interest rate and the futures are negatively correlated that does not mean convexity adjustment will make futures to be lower priced in the market than the forwards,but convexity adjustment always make futures to be higher priced in the market than the forwards,why because futures always have the advantage that their profits is received well ahead of time than forwards and can be invested in interest rate the effect is always positive that's why its convexity adjustment after combining the effect of both positive and negative correlations between interest rate and the futures .Just like in fixed income the increase and decrease of yield by equal amounts always ends in positive convexity adjustment that is increase in price of bond so decrease and increase effects of yield has a net positive effect on bond price similarly decrease and increase effects of correlation has a net positive effect on futures price relative to the forward price.

 

[Arka Bose]

Hi, thanks Shakti, I was revisiting the topic, after reading book, your replies and other threads, I realized where was the mistake in my interpretation. Thanks a lot!