Question 3 (20 marks)

a. Explain why the forward interest rate is less than the corresponding futures interest rate calculated based on a Eurodollar futures contract. (5 marks)

b. As a dealer in an international bank, you observed that the December Eurodollar futures contract is quoted as 97.50 and a corporate client of your bank plans to borrow USD10 million for three months starting in December at LIBOR plus 0.6% per annum.

1. What rate can the company lock in by using the Eurodollar futures contract?
   1. (2 marks)
2. What position and how many Eurodollar futures contracts should the company trade? (3 marks)
3. If the actual threemonth rate turns out to be 2.3% per annum, what is the final settlement price on the futures contracts? (3 marks)
4. Based on the actual rate in (iii), what is the effective borrowing cost for the company if it hedges using the Eurodollar futures contract? Is it a perfect hedge? Explain.

(7 marks)