What You Need To Know About the Fed Funds Rate

Fed funds futures and options allow traders to speculate on rate-hike changes from the Fed

The Fed funds rate is the interest rate banks use when they lend to each other, typically on an overnight basis. The federal funds rate essentially sets the tone for all other interest rates in the U.S., so the higher it is, the more it costs to borrow money. While the Fed doesn’t directly control the federal funds rate, which can fluctuate overnight, its actions hold sway, as the target for the Fed funds rate is set by the Federal Open Market Committee (FOMC). Fed funds futures and options contracts, meanwhile, allow investors to speculate on the probability of a quarter-point hike in the target rate — as we just saw earlier this week.

The pricing of Fed funds futures contracts is based on investor expectations of what the Fed’s next move will be, and comparing contracts for different months can give traders insight into how the Fed funds rate is expected to change. CME Group (CME) offers contracts from the current month to two years out. The probability of a rate hike for any particular month is found by adding the probabilities of all potential target rate levels above the current level.

Hedging a portfolio with Fed funds futures and option contracts can help traders protect themselves against sudden market moves based on Fed actions. In addition, watching the price action of Fed funds futures can give investors insight into the overall market expectations for interest rates in upcoming months. However, it is important to note that determining Fed rate hikes is far from an exact science, so it’s always best to use common sense and caution when deciding how to invest.