Pricing of the Eurodollar bank rate

Abstract

The Eurodollar bank rate has been widely viewed as one of the chief barometers of credit market conditions in the Eurocurrency markets, yet not enough is known about how this rate is determined. For example, most of the short-to-medium term loans made by banks in the Eurocurrency market are floating rate loans linked to the London Interbank Offered Rate (LIBOR). The Eurocurrency interbank market “encompasses over 1,000 banks from 50 different countries, with a total market size of $3.3 trillion . . . transactions in U.S. dollars are the most prominent.. [13, p. 171. The objective of this paper is to attempt to further our understanding of the pricing of the Eurodollar bank rate through an analysis of recent Eurodollar bank rate movements. Empirical studies on determination of the Eurodollar bank rate [l, 7,11,12], generally have viewed the Eurodollar market as a major financial intermediary that channels short-term funds among the money markets of industrial countries. In these studies, the dollar-denominated risk-free rate of return (U.S. Treasury bill rate) is taken to be the principal determinant of the Eurodollar bank rate.’ Moreover, these studies anticipate that the maximum adjustment in the Eurodollar bank rate will be on a one-to-one basis to changes in the U.S. Treasury bill rate. Using both quarterly and monthly data for 1957-64, Hendershott estimated a stock-flow adjustment equation of the “Koyck-Nerlove” type. He concluded that, “in response to a one percentage point rise in the mean U.S. bill rate, . . . the eventual increase in the Eurodollar rate will be . . . 1.07 percentage points. This is not significantly greater than the maximum anticipated value of unity” [7, p. 4621. Using a multiple regression approach and monthly data for the period 1961-71, Argy and Hodjera [l] showed that the maximum value of the estimated coefficient on the U.S. Treasury bill rate is 0.62. Mills [12], using a similar approach and weekly data for 1966-70, showed that the maximum value is 0.61. In this paper the basic relationship between the Eurodollar bank rate and a dollar-denominated risk-free rate of return (the U.S. Treasury bill rate) is examined.