What are 'Fed Funds Futures'?

Fed funds futures are financial contracts that represent 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. 

BREAKING DOWN '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 policy makers 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 month average. In 2016, the Fed funds future 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 per cent 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.

  1. Federal Reserve System - FRS

    The Federal Reserve System, commonly known as the Fed, is the ...
  2. Federal Funds

    Federal funds are excess reserves that commercial banks deposit ...
  3. Federal Funds Rate

    The federal funds rate is the interest rate at which a depository ...
  4. Open Market Operations - OMO

    Open market operations refer to the buying and selling of government ...
  5. Monetary Accord Of 1951

    The Monetary Accord of 1951 was an agreement between the U.S. ...
  6. Futures

    A financial contract obligating the buyer to purchase an asset ...
Related Articles
  1. Insights

    Fed Hikes 25 Basis Points, Signals Two More Hikes in 2017

    As expected the Fed raised the fed funds rate by 25 basis points.
  2. Insights

    The Fed's Concerns

    Wall Street traders have voiced doubts about the Fed’s intentions. On the one hand, they note how the minutes of the last Fed meeting expressed concerns about the stock market. Yet on the other, ...
  3. Personal Finance

    How the Federal Reserve Affects Your Mortgage

    The Federal Reserve can impact the cost of funds for banks and consequently for mortgage borrowers when maintaining economic stability.
  4. Trading

    Why Interest Rates Have Been Low for So Long

    Learn of several competing explanations about why the Federal Reserve has kept interest rates so low in the United States since 2008.
  5. Personal Finance

    How interest rate cuts affect consumers

    Traders rejoice when the Fed drops the rate, but is it good news for all? Find out here.
  6. Investing

    How Do Interest Rates Affect the Stock Market?

    Interest rates can have a complicated ripple effect through financial markets. Here's what you need to know.
  7. Investing

    How The Fed May Kill The 2018 Stock Rally

    Hawk Attack: A more hawkish Fed may spell trouble for stocks
  8. Insights

    Is the Fed Behind the Curve?

    Have Fed officials sat on their hands for too long?
  9. Investing

    How The Federal Reserve Fights Recession

    Discover the steps that the Federal Reserve has taken to help save the economy.
  1. How Central Banks Influence Money Supply

    Central banks use several different methods to increase (or decrease) the amount of money in the banking system. Learn more ... Read Answer >>
  2. Who controls the Federal Reserve Bank?

    Read about the ownership and control of the Federal Reserve, the most powerful financial institution in the world and the ... Read Answer >>
Hot Definitions
  1. Net Present Value - NPV

    Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows ...
  2. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing a company that measures its current share price relative ...
  3. Internal Rate of Return - IRR

    Internal Rate of Return (IRR) is a metric used in capital budgeting to estimate the profitability of potential investments.
  4. Limit Order

    An order placed with a brokerage to buy or sell a set number of shares at a specified price or better.
  5. Current Ratio

    The current ratio is a liquidity ratio that measures a company's ability to pay short-term and long-term obligations.
  6. Return on Investment (ROI)

    Return on Investment (ROI) is a performance measure used to evaluate the efficiency of an investment or compare the efficiency ...
Trading Center