What Are Fed Funds Futures How They re Traded and Settled
Fed Funds Futures: Trading and Settlement
Fed funds futures are financial derivatives traded on the Chicago Mercantile Exchange (CME) and are based on the federal funds rate. The federal funds rate is the interest rate at which banks lend each other money overnight, using reserves deposited at the Federal Reserve.
The Federal Reserve uses the federal funds rate as a tool to control the money supply and influence the cost of credit in the economy. The prices of Fed funds futures reflect market expectations about future changes in the Fed funds rate, which is an essential aspect of monetary policy.
Key Takeaways:
– Fed funds futures are derivatives linked to the federal funds rate, which is the overnight interbank lending rate on reserves held with the Fed.
– These futures contracts trade on the Chicago Mercantile Exchange and are settled in cash on a monthly basis.
– The fed funds rate is the benchmark interest rate used by the Fed to impact borrowing costs for businesses, consumers, and economic growth.
– Fed funds futures pricing can be converted into market-based odds for future changes in the target range for the fed funds rate.
Understanding Fed Funds Futures:
The federal funds rate is the shortest-term risk-free interest rate that sets a floor for other interest rates in the economy. When the fed funds rate increases, borrowing costs rise for various loans, and bond yields increase. Conversely, lower interest rates promote economic growth.
Banks and fixed-income portfolio managers use fed funds futures to hedge against short-term interest rate fluctuations and speculate on the Federal Open Market Committee’s monetary policy decisions.
Contract Specifications:
CME offers 30-day fed funds futures contracts listed for 60 consecutive months, settling on the last business day of each month. For instance, the longest-dated contract in June 2022 settled in May 2027. Options on fed funds futures contracts expiring within two years are also available.
The contract price for 30-day fed funds futures is the average of the daily effective federal funds rates during the contract month, subtracted from 100. The minimum contract size is determined by multiplying the contract price by $4,167.
Fed Funds Futures as Rate Hike Odds:
The prices of fed funds futures expiring after upcoming FOMC meetings are indicators of market expectations regarding future federal funds rate targets.
These market prices can be interpreted as probabilities of rate hikes or cuts at those meetings. However, it is crucial to understand that these probabilities reflect current market odds expressed through fed funds futures trading.
For instance, the fed funds futures contract expiring in July 2022 quoted a price of 98.32 on June 16, implying an expectation of an average effective Fed funds rate of 1.68% in July.
According to the CME’s Fed Watch Tool, this pricing indicated an estimated 86.2% probability of a 75 basis points fed funds increase at the FOMC’s July 27 meeting, with a 13.8% chance of a hike of 50 basis points. In mid-May 2022, market pricing indicated an 86.1% probability of a 25 basis points increase in July, but this outcome was entirely discounted a month later.
