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FRM Part I · FRM Exam Part I · Interest Rate Futures

A Eurodollar futures contract expiring in 2 years is quoted at 95.00 (implied rate 5.00%). The annualized standard deviation of the short-term rate change is 1.2% and the convexity adjustment uses forward rate = futures rate - 0.5 x sigma^2 x t1 x t2, with t1 = 2.00 and t2 = 2.25 years. What is the forward rate, to the nearest basis point?</br>

The convexity adjustment is 0.5 x 0.012 squared x 2.00 x 2.25, which is about 3.24 basis points. Futures rates exceed forward rates because of daily settlement, so the forward rate is 5.00% minus 0.03%, about 4.97%.

  1. A4.97%Correct
  2. B4.68%
  3. C5.03%
  4. D4.84%

Explanation

Adjustment = 0.5 x 0.012^2 x 2.00 x 2.25 = 0.5 x 0.000144 x 4.5 = 0.000324 = 3.24 bp. Forward = 5.00% - 0.0324% = 4.9676%, about 4.97%. Adding the adjustment gives 5.03%, which has the wrong sign: futures rates exceed forward rates.

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