Key Takeaways
- Fed funds futures are contracts traded on the CME that mirror changes in the federal funds rate.
- These futures are cash-settled monthly and help predict economic outcomes like rate hikes or cuts.
- Fed funds futures pricing can indicate market expectations for Federal Reserve policy changes.
- Banks and traders use fed funds futures to hedge against interest rate fluctuations and speculate on policy.
- Contract prices are calculated from the average daily fed funds rate, subtracted from 100.
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What Are Fed Funds Futures?
Fed funds futures are financial contracts traded on the Chicago Mercantile Exchange (CME) that track the federal funds rate, which is the overnight lending rate between banks. Their prices reflect market expectations of future rate changes, allowing banks and traders to hedge or speculate on U.S. interest rates influenced by Federal Reserve policy.
How Fed Funds Futures Affect the Economy
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.
Key Specifications of Fed Funds Futures Contracts
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.
Interpreting Rate Hike Odds With Fed Funds Futures
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 indicated a 95.9% chance that the Federal Reserve would keep rates at 525-550 basis points during the July 31, 2024, FOMC meeting. The remaining 4.1% suggested a possible rate cut to 500-525 basis points.
This marked an increase from the April 2024 futures contracts, which had shown a 77.23% probability that rates would remain unchanged by the end of the July FOMC meeting.
Is SOFR the Same as Fed Funds?
No, the secured overnight financing rate (SOFR) and the effective federal fed funds rate (EFFR) are not the same. SOFR is an overnight lending rate that uses Treasuries as collateral while the fed funds rate is the base interest rate of the U.S. calculated from overnight loans without collateral.
What Is the Difference Between OIS and SOFR?
An overnight index swap (OIS) is a hedging contract where two counterparties exchange a cash flow that has already been decided. There are two legs: a floating leg and a fixed leg of cash flows. The floating leg is calculated based on an overnight rate. That overnight rate can be the secured overnight financing rate (SOFR), the fed funds rate, or another rate. So OIS is a financial product used for hedging while SOFR is an overnight interest rate that can be used in the calculation of the floating rate component of an OIS.
Is Fed Funds a Secured Rate?
No, fed funds is not a secured rate. It involves the borrowings by domestic depository institutions from other domestic depository institutions or other domestic entities, such as government-sponsored ones. These borrowings are unsecured.
The Bottom Line
Fed funds futures are a tool used by traders and institutions to hedge or speculate on changes in the federal funds rate. They reflect market expectations for interest rate moves, especially before Federal Reserve meetings, and help anticipate how rate changes could affect borrowing costs and overall economic growth.