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You Can Trade Options and Futures on the Fed Funds Rate

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Interest rates have been in focus lately, especially the effect of the actions of the US Federal Reserve Board on equity prices. I figured it would be a good time to explain how the Fed Funds futures and options contracts at the CME Group (CME - Free Report) work. Like all listed futures and options, they can be used to hedge an existing position against a move in interest rates or to speculate on the speed and direction of expected changes.

With interest rates at all-time lows, yesterday’s meeting of the Board of the Federal Reserve was the first of many that will be closely watched by traders and investors. We’re in an interesting position in which pretty much everyone knows that interest rates are going to rise at some point, but nobody knows when or how much.

In the post-meeting press conference, Fed Chairman Powell significantly downplayed current inflationary risks and a survey of the entire board estimates that by the end of 2023, the Fed Funds rate will be 0.62% - implying only two 25 basis-point increases over the next 18-30 months.

Since 2008, the Fed has kept rates historically low to counter recessionary pressures. Those rates were creeping back toward historical averages when the pandemic hit in 2020, bringing the potential of deep economic problems and necessitating a return to near-zero short term rates as well as huge bond purchases by the Fed that have kept yields low along the entire curve.

So far, Powell and the Fed Board have handled the situation spectacularly well, providing a massive dose of liquidity that kept the markets functioning and steering us toward a full recovery that has included an unprecedented rise in equity prices. Those aren’t the only prices that are rising however, commodities, labor and consumer goods are gaining ground as well. It’s clear that rates will have to rise at some point to head off inflation.

Yesterday the Fed voted to keep rates unchanged, maintain the same level of asset purchases and continued to use the word “transitory” to describe recent data indicating rapidly rising prices.

When rates do rise, they will simply be returning toward long-term average levels, but equity investors are jittery about the effect on earnings and valuations. The dreaded “taper tantrum” in which stocks are sold as the Fed reduces the level of asset purchases is fairly likely.

Though it sounds counterintuitive, the Fed doesn’t “set” the Fed Funds Rate. Banks that borrow from the Fed to meet overnight capital requirements pay the Discount rate. The rate at which financial institutions borrow and lend among themselves is known as the “Fed Funds” rate. That interbank activity makes up the vast majority of overnight loans, at least partly because the Fed charges more – typically around 100 basis points more. The Fed wants to be the lender of last resort and let most of the action play out between banking institutions themselves.

The Fed does set a “target” rate range for Fed Funds lending activity - and that’s the number that you see quoted daily and discussed around Fed meetings. The Fed constantly conducts open market operations, buying and selling securities that ensure that the actual rate banks are charging each other is inside the target range.  

CME Fed Funds Futures

The Fed Funds futures traded on the CME are priced as 100 minus the effective current rate. For instance, an interest rate of 1.5% would translate to a futures price of 98.50. This has been the convention for all CME International Monetary Market products since the introduction of the Eurodollar futures in 1981 and produces a futures price which approximates how bond prices are typically quoted as a percentage of par value.

Like bond prices, the index increases when rates fall and falls when rates rise.

The futures are cash-settled on a monthly basis on the last business day of the calendar month. Contrary to popular belief, the final settlement value is not the midpoint of the Fed’s target range.

The CME Fed Funds futures follow the actual rate at which interbank lending is taking place. The final value is the unweighted average of each observed daily Fed Funds rate during that month, as calculated by the Federal Reserve Bank of New York.

As an example, the Fed’s target rate of 0-25 basis points hasn’t changed in over a year. The midpoint of that range is 12.5 bps, but that’s not exactly where the futures have been settling. In April, the final settlement value was 99.931 – implying an average rate during the month of 6.9 bps.

The contract multiplier is 4,167. If the index increases by one point, the owner of a long contract makes $4,167. That might seem like a lot – especially compared to S&P 500 mini futures that have a multiplier of just $50 – until you consider the fact that the Fed Board is expecting just 50 basis points (half an index point) of movement over the next two years or so.

The minimum tick is ½ of one basis point, or a little over $20.

Options on Fed Funds futures work substantially the same way as other futures options we’ve seen before in Know Your Options. The underlying for each option is one futures contract and monthly expirations are listed two years out into the future. The options are “American style” and can be exercised any time prior to expiration.

The last trading day is the final business day of the month and the minimum tick size is ¼ basis point, or a bit more than $10.

There’s one more unique consideration when you’re trading options on indexed interest rate products. The implied volatility is based on the interest rate itself, not the index value. That means they’re going to look a lot higher that you might expect if you’re used to trading equities. If the Fed Funds futures are trading 99, the vol is based on the movement of a $1 asset – the rate itself – not a $99 asset.

Speculating on interest rates is challenging. I once heard a very successful trader say, “You want to know where the 30-year (Treasury) is going to be in a year? The best bet is exactly where it is right now. Billions of dollars a day flow through those markets every day and the current price represents all available information. If you think you’re smarter than the collective wisdom all of those people combined, by all means make your bet. But you’re really just flipping a coin.”

The Fed Funds rate is a little different because it’s the result of the decisions of a relatively small number of people – the Board – and unlike traders, they have no reason not to be entirely transparent about their motives.

Heading into yesterday’s announcement, the futures activity suggested a 5-18% chance of a rate increase. Obviously it didn’t happen and the futures for the rest of 2021 have now retreated back toward zero Fed Funds rates.

So it’s an interesting product. If you have a desire to hedge or speculate on the actions of the Fed, these contracts are just as easy to use as any other futures options, as long as you understand their unique aspects.

-Dave

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