What Are Fed Funds Futures?
Fed funds futures are financial contracts that represent the market opinion of where the daily official federal funds rate will be at the time of the contract expiry. The futures contracts are traded on the Chicago Mercantile Exchange (CME) and are cash settled on the last business day of every month. Fed fund futures can be traded every month as far out as 36 months.
Understanding Fed Funds Futures
Fed funds futures are used by banks and fixed-income portfolio managers to hedge against fluctuations in the short-term interest rate market. They are also a common tool traders use to take speculative positions on future Federal Reserve monetary policy. The CME group has created a tool that uses fed funds futures contracts to determine the probability of the Federal Reserve changing monetary policy at a particular meeting, which has become a useful tool in financial reporting.
Most financial markets are affected by the Fed funds rate, the U.S. central bank’s interest rate. The trend in the Fed Funds futures rate reflects what investors expect policymakers to do with the rate.
The contract price is 100 minus the effective Fed Funds rate. For example, in December 2015, the contract was trading at 99.78, this implied that investors were predicting an interest rate of 0.22%. But that was the monthly average. In 2016, the Fed funds futures contract for that month was trading at 99.19, which implies that the average Fed funds rate is 0.81% for that month. Then, the Fed funds futures market reflects a 74% chance of the central bank lifting interest rates for the next month, according to Bloomberg, while the CME calculates a 73.6% chance, based on the same contracts.
However, both Bloomberg and the CME’s estimates underestimate the likelihood that markets will take off in December. This is partly because the Fed changed the interest rate range following the financial crisis of 2008. Instead of tweaking the amount of money in the system to target a single Fed funds rate, which is traditionally done to affect monetary policy, the U.S. central bank in 2008 moved to from a 0% range to a 0.25% range. Thus, the effective Fed funds rate has traded within this range since then and averaged approximately 13.2 basis points.
The interest rate rise calculation for futures contracts depends on whether the Fed returns to a specific target or lifts its range by 25 basis points. The Fed will set the new range, and the reaction of investors to the two rates determines the calculation of the probability of an increase implied by futures. For example, if the effective Fed funds rate is closer to the lower end of the central bank’s range, the likelihood of a rate rise implied by Fed funds futures contracts is higher. If the effective Fed funds rate increases by 37.5 basis points, then the probability is approximately 70%. However, if the effective Fed funds rate is in the higher range, then the likelihood of a rate rise is lower.