Fed Funds Futures

What Are Fed Funds Futures?

Fed funds futures are financial futures contracts based on the federal funds rate and traded on the Chicago Mercantile Exchange (CME) operated by CME Group Inc. (CME). The federal funds rate is the rate banks charge each other for overnight loans of reserves on deposit with the Federal Reserve.

The Fed utilizes the federal funds rate to control U.S. money supply and influence the cost of credit all through the economy. The prices of Fed funds futures reflect market expectations about future changes in the Fed funds rate based on the target goes the Fed sets as a key device of its monetary policy.

Grasping Fed Funds Futures

As the shortest-term risk-free interest rate, the federal funds rate sets the floor for other interest rates all through the economy. Increases in the fed funds rate raise borrowing costs for a wide assortment of new and variable-rate loans, and drive up bond yields. Alternately, when the fed funds rate drops, other interest rates will more often than not decline too. Lower interest rates advance quicker economic growth, while higher ones frequently sluggish it.

Banks and fixed-income portfolio managers utilize fed funds futures to hedge against market changes in short-term interest rates. The contracts additionally let traders conjecture on the Federal Open Market Committee's monetary policy declarations.

Contract Specifications

CME's 30-day fed funds futures are month to month contracts listed for 60 successive months and cash settled on the last business day of each and every month. For instance, the longest-dated fed funds futures contract on the CME in June 2022 was due to get comfortable May 2027. The CME additionally records options on fed funds futures contracts lapsing in two years or less.

The 30-day fed funds futures' contract price is the arithmetic average of the daily effective federal funds rates during the contract month as reported by the Federal Reserve Bank of New York, deducted from 100. So assuming the effective fed funds rate were to average 1.75% for a given month, the settlement price of the fed funds futures contract terminating that month would be 100 - 1.75 = 98.25.

The base contract size is communicated in U.S. dollars by increasing the contract price by $4,167. In the model above, it would be 98.25 x $4,167 = $409,407.75.

Options on the fed funds futures contracts are American-style, meaning they can be practiced on any business day prior to expiration.

Fed Funds Futures as Rate Hike Odds

The prices of fed funds futures lapsing after FOMC meetings not yet held mirror the market expectations for the outcome of those meetings in terms of federal funds rate targets.

Those market prices can be communicated as probabilities of rate hikes (or cuts) of a given size at those meetings, and CME's Fed Watch Tool gives these. It is important to comprehend that the probabilities reflect not the objective probability of a given outcome yet rather current market chances as communicated in fed funds futures trading.

For instance, the fed funds futures contract terminating in July 2022, was quoted at 98.32 on June 16, reflecting expectations the effective Fed funds rate would average 1.68% in July.

As per the CME's Fed Watch Tool, this pricing mirrored an estimated 86.2% likelihood of a 75 basis points fed funds increase at the FOMC's July 27 meeting, and a 13.8% chance of a climb of 50 basis points. In mid-May 2022, market pricing mirrored a 86.1% likelihood the July increase would be just 25 basis points, an outcome completely discounted a month after the fact.

Features

• Fed funds futures are traded on the Chicago Mercantile Exchange and are cash settled consistently.
• The fed funds rate is the benchmark interest rate the Fed uses to influence borrowing costs for businesses and consumers and the pace of economic growth.
• Fed funds futures pricing can be changed over into market-based chances of future Fed declarations of changes in the's fed funds rate target range.
• Fed funds futures are derivatives based on the federal funds rate, the U.S. overnight interbank lending rate on reserves deposited with the Fed.