Empirical Investigation of the Size and the Nature of the Eurodollar Futures-Forward Differential

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We investigate the magnitude of the forward-futures differential, also known as the convexity adjustment, for Eurodollar interest rate instruments and attempt to identify factors affecting its size using an extensive sample for the 1988-2007 period. The innovative feature of our analysis is that the construction of the differential is extended from using rates for maturities up to twelve months as in previous published research to rates for maturities up to three years through the use of swap rates that allows us to build the extended term structure of spot and forward rates. Opposite to the previous findings, we find that the magnitude of the forward-futures differential is much smaller than what was reported in earlier studies, and that its sign is negative on many occasions which contradicts theoretical implications. We further check for potential data skews and other imperfections that may be behind the obtained results and find that neither asynchronicity bias, nor the unconventional feature of the Eurodollar futures pricing can explain the observed phenomena. The term structure interpolation error and the two business day lag between the fixing (settlement) date and the transaction (value) date the implied forward rates and prices are applied to cannot be attributed to the observed abnormality either. We also find that the level of interest rates is a significant positive factor behind the differential and its explanatory power is magnified if the regression analysis is conducted for the price differential instead of that for the rate differential which also results in a better goodness-of-fit.