Federal funds futures

What Is Federal Funds Futures?

Federal funds futures are financial derivatives contracts that allow market participants to speculate on or hedge against future changes in the federal funds rate. As a key instrument within interest rate markets, these futures contracts provide valuable insight into market expectations regarding the future direction of U.S. monetary policy. Traded primarily on the Chicago Mercantile Exchange (CME), federal funds futures are widely used by banks, institutional investors, and traders to manage exposure to short-term interest rate fluctuations and to gauge potential actions by the Federal Reserve.

History and Origin

The concept of federal funds futures emerged from the growing need for market participants to anticipate and manage the impact of Federal Reserve actions on short-term interest rates. Federal funds futures contracts began trading on the floor of the Chicago Board of Trade (CBOT), now part of the CME Group, in October 1988. Their introduction provided a standardized, market-based tool for forecasting the future federal funds rate, a rate directly targeted by the Federal Reserve as its primary instrument of monetary policy. Early research recognized the ability of these futures rates to embody rational forecasts of the spot rate, demonstrating that short-term changes in Federal Reserve policy contained a significant systematic component that financial markets could accurately anticipate.⁵

Key Takeaways

• Federal funds futures are derivative contracts based on the monthly average of the effective federal funds rate.
• They serve as a key indicator of market expectations for future Federal Reserve interest rate policy.
• Traders and institutions use federal funds futures for both speculation on interest rate movements and hedging against interest rate risk.
• The contract price is quoted as 100 minus the expected average federal funds rate for the contract month.
• Federal funds futures are cash-settled upon expiration, based on the actual arithmetic average of the effective federal funds rate for that month.

Formula and Calculation

The price quotation for federal funds futures contracts is derived from the anticipated average effective federal funds rate for the contract month. The price is expressed as an index value, calculated by subtracting the expected average rate from 100.

The formula is:

Where:

• (\text{R}) = The arithmetic average of the daily effective federal funds rates during the contract month, expressed as an annualized percentage.

For example, if the market expects the average effective federal funds rate for a given month to be 5.25%, the federal funds futures price for that month would be:

Conversely, if a federal funds futures contract is trading at 94.75, the implied average federal funds rate for the contract month is 5.25%. This conversion makes it straightforward for market participants to interpret the price in terms of the underlying interest rate. The minimum price fluctuation, or tick size, is typically 1/4 of one basis point, equivalent to $10.4175 per contract.⁴

Interpreting the Federal Funds Futures

Interpreting federal funds futures prices offers direct insight into how the market anticipates future short-term interest rates and, consequently, the likely actions of the Federal Reserve's rate-setting body, the Federal Open Market Committee (FOMC). A higher futures price (closer to 100) suggests expectations of a lower average federal funds rate, while a lower price implies expectations of a higher rate.

By observing the prices of contracts expiring in different months, analysts can construct a forward curve of implied federal funds rates, which reflects the market's collective forecast for the Fed's policy trajectory. Significant price changes often occur in response to economic data releases, Federal Reserve communications, or other events that might influence monetary policy. For instance, if a contract for a future month drops significantly, it suggests the market is pricing in a higher probability of an interest rate hike by the FOMC.

Hypothetical Example

Consider an investor, Sarah, who believes the Federal Reserve is likely to raise the federal funds rate by 25 basis points at its next FOMC meeting, which is scheduled mid-month for the upcoming September contract. The current federal funds rate target is 5.00%-5.25%.

The September federal funds futures contract is currently trading at 94.80. This implies an average effective federal funds rate of (100 - 94.80 = 5.20%) for September.

Sarah's expectation of a 25-basis point hike would suggest an average rate closer to (5.25% + 0.25% = 5.50%) for the latter part of the month, which would pull the monthly average higher. If the rate hike occurs as expected and the average effective federal funds rate for September turns out to be 5.40%, the futures contract would settle at 94.60.

• Initial Implied Rate: (100 - 94.80 = 5.20%)
• Sarah's Expected Rate (post-hike influence): (\approx 5.40%)
• Futures Price if Sarah is correct: (100 - 5.40 = 94.60)

If Sarah had entered a short position in the September federal funds futures contract, she would profit from the price decline, effectively benefiting from her correct anticipation of the interest rate increase. This example illustrates how federal funds futures allow participants to act on their views about future monetary policy and interest rate movements.

Practical Applications

Federal funds futures are instrumental in various aspects of financial markets, serving both as a forecasting tool and a risk management instrument. Their primary applications include:

• Monetary Policy Forecasting: The prices of federal funds futures provide real-time, market-derived probabilities of future FOMC target rate changes. Tools like the CME FedWatch Tool leverage these futures prices to estimate the likelihood of rate hikes or cuts at upcoming meetings, offering a widely cited gauge of market sentiment regarding the Federal Reserve's path.³
• Hedging Interest Rate Risk: Financial institutions, such as banks and portfolio managers, use federal funds futures to mitigate exposure to fluctuations in short-term interest rates. For example, a bank anticipating a rise in borrowing costs might sell federal funds futures to offset potential losses on its fixed-income holdings.
• Speculation: Traders actively use federal funds futures to express their views on the future direction of the federal funds rate. If a trader believes the Fed will raise rates more aggressively than currently priced, they might sell futures contracts.
• Arbitrage Opportunities: Sophisticated traders may identify and exploit small discrepancies between the implied rates from federal funds futures and other short-term interest rate instruments, such as Treasury bills or repurchase agreements.
• Yield Curve Analysis: The series of prices across different federal funds futures contract months helps to construct a forward curve that reflects the market's expectation of future short-term rates, influencing broader yield curve analysis and investment decisions.

Limitations and Criticisms

While federal funds futures are a highly valuable tool, they are not without limitations. One key consideration is the presence of risk premiums. Futures prices can embed a risk premium that compensates market participants for holding the contract, meaning the implied rate might not be a perfectly unbiased forecast of the future spot rate. Research from the Federal Reserve Bank of New York has explored how to adjust federal funds futures rates for these time-varying risk premiums using business cycle data to obtain a less biased measure of predictability.²

Furthermore, the "backward-looking" nature of the contract can sometimes complicate interpretation. The final settlement price is based on the average of the daily effective federal funds rates throughout the entire contract month¹. If an FOMC meeting and a rate change occur mid-month, the first contract fully reflecting the rate change would be the next deferred contract month, rather than the one in which the meeting takes place. This can lead to a blending effect in the current month's contract price, where only a portion of the month reflects the new rate. This nuance requires careful consideration, especially for contracts expiring in months with scheduled FOMC meetings.

Market liquidity, while generally high for near-term contracts, can decrease for contracts further out on the forward curve, potentially making their implied rates less precise indicators of long-term expectations.

Federal Funds Futures vs. Eurodollar Futures

While both federal funds futures and Eurodollar futures are crucial instruments in short-term interest rate markets, they differ fundamentally in their underlying assets and the interest rates they track.

Federal funds futures are directly tied to the effective federal funds rate, which is the overnight interbank lending rate for reserves held at the U.S. Federal Reserve. This rate is the primary target of the Federal Reserve's monetary policy and directly reflects domestic U.S. banking system liquidity.

Eurodollar futures, on the other hand, are based on the London Interbank Offered Rate (LIBOR) for U.S. dollar deposits, typically the three-month LIBOR, or more recently, the Secured Overnight Financing Rate (SOFR) as LIBOR is phased out. Eurodollars represent U.S. dollar-denominated deposits held in banks outside the United States. While Eurodollar futures are highly sensitive to U.S. interest rate policy, they also incorporate a credit risk component related to the creditworthiness of the banks lending in the Eurodollar market, which federal funds futures do not. Federal funds futures are considered a more direct reflection of U.S. monetary policy expectations, while Eurodollar futures reflect broader money market conditions and interbank lending sentiment.

FAQs

Q: What is the effective federal funds rate?
A: The effective federal funds rate is the volume-weighted median of overnight federal funds transactions by depository institutions. It represents the rate at which banks lend their excess reserves to other banks on an overnight basis.

Q: How do federal funds futures predict Federal Reserve actions?
A: The prices of federal funds futures reflect the collective expectation of market participants regarding the average federal funds rate for a future month. By analyzing changes in these prices, particularly around FOMC meetings, analysts can infer the market's perceived probability of an interest rate change.

Q: Are federal funds futures cash-settled or physically delivered?
A: Federal funds futures contracts are cash-settled. Upon expiration, there is no physical delivery of any underlying asset; instead, the profit or loss is calculated based on the difference between the trading price and the final settlement price, which is the actual arithmetic average of the daily effective federal funds rate for that month.

Q: Who uses federal funds futures?
A: Federal funds futures are primarily used by large financial institutions, commercial banks, investment banks, hedge funds, and sophisticated individual traders. They utilize these derivatives for hedging interest rate risk, speculating on future monetary policy, and managing short-term funding costs.

Q: Where are federal funds futures traded?
A: Federal funds futures are predominantly traded on the Chicago Mercantile Exchange (CME), which is part of the CME Group. They are highly liquid instruments, especially for near-term contract months.