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. Term Fed Funds

    Term Fed funds refer to funding that a bank raises in the Fed ...
  2. FED Pass

    A Fed pass happens when the U.S. central bank increases the availability ...
  3. Federal Funds Rate

    The federal funds rate is the interest rate at which a depository ...
  4. Key Rate

    The key rate is the specific interest rate that determines bank ...
  5. Intermediate Targets

    Intermediate targets are set by the Federal Reserve as part of ...
  6. Open Mouth Operations

    Open mouth operations are speculative statements made by the ...
Related Articles
  1. Insights

    7 Misconceptions About The Federal Reserve

    There are many fallacies about the Fed. The following misconceptions are among the most popular.
  2. 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.
  3. Insights

    The Fed, Investors, Economists Now Love Rate Hikes

    Interest Rate Harmony: a consensus has emerged that several rate hikes are needed
  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. Insights

    Translating "Fed Speak" Into Plain English

    Confused by the Fed's lingo? Find out what it can tell you and learn how to decipher it.
  6. Financial Advisor

    How the Fed Fund Rate Hikes Affect the US Dollar

    Learn about the effects the federal funds rate on the U.S. dollar. Understand what happens when the Federal Reserve increases interest rates.
  7. Investing

    The Fed's Tools for Influencing the Economy

    The economy can be volatile when left to its own devices. Find out how the Fed smoothes things out with their economic crisis-fighting tools.
  8. Insights

    Fed Officials See Up To Four More Rate Hikes in 2017

    Rosengren said a hike at "every other" meeting this year is warranted.
  1. What is the relationship between inflation and interest rates?

    As interest rates are lowered, more people are able to borrow more money, causing the economy to grow and inflation to increase. ... Read Answer >>
  2. Who determines interest rates?

    Learn who determines interest rates. In countries using a centralized banking model, interest rates are determined by the ... Read Answer >>
Trading Center