You can trade options and futures on the federal funds rate

Interest rates have been the focus of concern lately, particularly the effect of US Federal Reserve actions on stock prices. I thought this would be a good time to explain how Fed Funds Futures and Options in the CME Group (CME) job. Like all listed futures and options, they can be used to hedge an existing position against a change in interest rates or to speculate on the speed and direction of expected changes.

With interest rates at historic lows, yesterday’s Federal Reserve Board meeting was the first in a long series that will be closely watched by traders and investors. We’re in an interesting position where pretty much everyone knows that interest rates are going to rise at some point, but no one knows when or how much.

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

Since 2008, the Fed has kept rates historically low to counter recessionary pressures. These rates were slowly rising back to historical averages when the pandemic hit in 2020, bringing the potential for deep economic problems and requiring a return to near zero short-term rates as well as huge bond purchases by the Fed that have kept yields low throughout the year. curve.

So far, Powell and the Fed Board have handled the situation in spectacular fashion, providing a massive dose of liquidity that kept the markets functioning and led us to a full recovery that included an unprecedented rise in stock prices. . These are not the only prices to rise, but raw materials, labor and consumer goods are also gaining ground. It is clear that rates will have to rise at some point to avoid inflation.

Yesterday the Fed voted to keep rates unchanged, maintain the same level of asset purchases and continued to use the word “transient” to describe recent data indicating a rapid rise in prices.

When the rates do increase, they will simply revert to long-term average levels, but equity investors are nervous about the effect on earnings and valuations. The dreaded “taper tantrum” in which stocks are sold as the Fed cuts the level of asset purchases is quite likely.

Although it seems counterintuitive, the Fed does not “fix” 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 between themselves is known as the “Fed Funds” rate. This interbank activity makes up the vast majority of overnight lending, at least in part because the Fed charges more, typically around 100 basis points more. The Fed wants to be the lender of last resort and let the bulk of the action take place between the banking institutions themselves.

The Fed sets a “target” rate range for Fed Funds lending activity – and that’s the number you see quoted daily and discussed at Fed meetings. The Fed continuously conducts open market operations, buying and selling securities that ensure that the actual rate that banks charge each other is within the target range.

CME Fed Funds Futures

Futures contracts on Fed Funds traded on the CME are valued at 100 minus the current effective rate. For example, an interest rate of 1.5% would result in a forward price of 98.50. This has been the convention for all CME international money market products since the introduction of Eurodollar futures in 1981 and produces a futures price that approximates how bond prices are typically quoted as a percentage of the nominal value.

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

Futures are settled in cash 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.

CME Fed Funds futures follow the real rate at which interbank loans are made. The end value is the unweighted average of each daily Fed Funds rate observed during that month, as calculated by the Federal Reserve Bank of New York.

For example, the Fed’s target rate of 0 to 25 basis points has not changed for over a year. The midpoint of this range is 12.5 basis points, but that’s not exactly where futures have moved. In April, the final settlement value was 99.931 – implying an average rate during the month of 6.9 basis points.

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

The minimum tick is ½ basis point, or just over $ 20.

Options on Fed Funds futures work much the same as the other options on futures we have seen before in Know Your Options. The underlying of each option is a futures contract and monthly expirations are listed two years into the future. The options are “American style” and can be exercised at any time prior to expiration.

The last trading day is the last business day of the month and the minimum tick size is ¼ basis point, or just over $ 10.

There is another unique consideration when trading options on indexed interest rate products. Implied volatility is based on the interest rate itself, not the index value. This means that they are going to look a lot higher than what you might expect if you are used to trading stocks. If Fed Funds futures are trading at 99, the theft is based on the movement of an asset at $ 1 – the rate itself – and not on an asset at $ 99.

It is difficult to speculate on interest rates. I once heard a very successful trader say, “You want to know where the 30 years (Cash) will be in a year? The best bet is exactly where it stands right now. Billions of dollars a day pass through these markets every day and the current price represents all the information available. If you think you are smarter than the collective wisdom of all of these people put together, take your gamble by all means. But you are really flipping a coin.

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

Prior to yesterday’s announcement, futures activity suggested a 5-18% chance of a rate hike. Obviously, that did not happen and futures contracts for the remainder of 2021 have now retreated to zero rates for Fed Funds.

It is therefore an interesting product. If you want to hedge or speculate on Fed stocks, these contracts are just as easy to use as any other futures option, as long as you understand their unique aspects.

-Dave

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