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 uses the federal funds rate to control U.S. money supply and influence the cost of credit throughout the economy. The prices of Fed funds futures reflect market expectations about future changes in the Fed funds rate based on the target ranges the Fed sets as a key tool of its monetary policy.
Key Takeaways
- Fed funds futures are derivatives based on the federal funds rate, the U.S. overnight interbank lending rate on reserves deposited with the Fed.
- Fed funds futures are traded on the Chicago Mercantile Exchange and are cash settled on a monthly basis.
- 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 converted into market-based odds of future Fed announcements of changes in the Fed's fed funds rate target range.
Understanding Fed Funds Futures
As the shortest-term risk-free interest rate, the federal funds rate sets the floor for other interest rates throughout the economy. Increases in the fed funds rate raise borrowing costs for a wide variety of new loans of all types and existing variable-rate loans, and drive up bond yields. Conversely, when the fed funds rate drops, other interest rates tend to decline as well. Lower interest rates promote faster economic growth, while higher ones often slow it.
Banks and fixed-income portfolio managers use fed funds futures to hedge against market fluctuations in short-term interest rates. The contracts also let traders speculate on the Federal Open Market Committee's monetary policy announcements.
Contract Specifications
CME's 30-day fed funds futures are monthly contracts listed for 60 consecutive months and cash settled on the last business day of every month. The CME also lists options on fed funds futures contracts expiring within two years.
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, subtracted from 100. So if the effective fed funds rate were to average 1.75% for a given month, the settlement price of the fed funds futures contract expiring that month would be 100 - 1.75 = 98.25.
The minimum contract size is expressed in U.S. dollars by multiplying the contract price by $4,167. In the example 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 exercised on any business day prior to expiration.
Fed Funds Futures as Rate Hike Odds
The prices of fed funds futures expiring after FOMC meetings not yet held reflect the market expectations for the outcome of those meetings in terms of federal funds rate targets.
Those market prices can be expressed as probabilities of rate hikes (or cuts) of a given size at those meetings, and CME's Fed Watch Tool provides these. It is important to understand that the probabilities reflect not the objective likelihood of a given outcome but rather current market odds as expressed in fed funds futures trading.
For example, the fed funds futures contract expiring in July 2024, expressed a 95.9% probability that the Fed would remain at 525-550 basis points during the July 31, 2024 FOMC meeting. The remaining 4.1% of probability was for the Fed cutting rates to 500-525 basis points. This represented an increase in the probability of rates remaining unchanged at the July 31, 2024 meeting from the probabilities given by the contracts expiring in April 2024. Those contracts had it at 77.23% that rate would remain unchanged at the end of July FOMC meeting.