Relationship between Treasury bills and Eurodollars: Theoretical and Empirical Analyses

In this paper, we derive an equilibrium relationship between the yields on Eurodollar and Treasury bills based on equivalent martingale results derived by Harrison and Kreps (<CitationRef CitationID="CR23">1979</CitationRef>) and Harrison and Pliska (<CitationRef CitationID="CR24">1981</CitationRef>, <CitationRef CitationID="CR25">1983</CitationRef>) as well as the corporate debt pricing model developed by Merton (<CitationRef CitationID="CR38">1974</CitationRef>). The derived equilibrium relationship incorporates the models used by Booth and Tse (<CitationRef CitationID="CR4">1995</CitationRef>) and Shrestha and Welch (<CitationRef CitationID="CR44">2001</CitationRef>) as special cases. The equilibrium relationship indicates that the conditional volatility of the yield on Eurodollars explains the variation in the TED spread. We empirically test the equilibrium relationship using a GARCH-M model and the concept of fractional cointegration. We use both the ex ante data implied by the respective futures contracts as well as the ex post spot data with daily, weekly and monthly frequencies. We find empirical support for the Equilibrium relationship. Copyright Springer Science+Business Media, LLC 2007