Q & A with Emily Hollis

Emily Hollis
July 10, 2008 | COMMENTS

Question: How do you read Fed Funds futures contracts and how do they work?

The Federal Funds futures contract trades on the Chicago Board of Trade twenty-four months out—one contract for each month. However, prices are rarely quoted beyond six months. The price quoted is quoted at 100 minus the effective Fed Funds rate, i.e., 97.50 percent for a project 2.50 percent rate. This rate represents the market's expectations of the overnight Fed Funds rate. Using these contracts, one can place a “probability” on when and by how much the Federal Reserve's Federal Open Market Committee (FOMC) will move rates.

Here's an example of how to read Fed movement probability. In theory, there are three outcomes of the FOMC meeting—it can raise, lower, or maintain the target Fed Funds rate. But in reality, the market is concerned with only two outcomes: Will the FOMC raise the Fed Funds rate or won't it? If the FOMC changes the Fed Funds rate, the amount is likely to be in 25 basis point (b.p.) increments, i.e. 25 b.p., 50 b.p., 75 b.p., or 100 b.p.

Now, let's assume that the Fed Funds contract three months out is trading at a price of 97.10, for an implied rate of 2.90 percent. The contract is trading 90 b.p. higher than the present target Fed Funds of 2.00 percent. Since interest rates are rising, you would take the lower band of a Fed Funds target rate, 2.75, and subtract from 2.90. Take the 15 b.p. and divide by the 25 b.p. movement (60 percent). We can conclude that three months from now, according to the futures contract, there is a 60 percent probability that the Fed will increase rates to 3.00 percent and a 40 percent probability that the target Fed Funds rate will be at 2.75 percent.

In this example, the contract is trading higher than the current target rate of 2.00 percent. Again, since the Fed generally moves in increments of 25 b.p., this reading of a projected 2.90 target rate indicates that there is a 100 percent probability that rates will be higher than 2.50 percent.

Here is an example of how the contracts actually work. The notional amount of one contract is $5 million. If you buy a contract at 97.10, your contract is worth $404,583.33 which is the notional amount times the contract price divided by 100 and divided by 12. If interest rates remain at 2.00 percent target funds, at expiration date, you sell the contract at 98.00, or $408,333.33 for a gain of $3,750.00. Theoretically, you could take your $5 million in three months and invest in funds for one month at 2.00 percent to earn $8,333.33; by adding the futures contract, you earned an additional $3,750.00 which results in total earnings of $12,083.33 and a locked-in rate of 2.90 percent.

Of course, these are general examples of how these contracts work. The probability as shown above can be further refined for the contracts trade, given actual fed funds rates rather than target rates. In addition, the contracts are cash instruments that settle on the first of the month and the FOMC rarely meets then, so calculation components may also include the number of days before and after the FOMC meetings.

It's a great theory, but the question remains: Will or won't the FOMC raise the Fed Funds rate? Tough question!

Emily Hollis is a CFA and president of ALM First Financial Advisors, LLC in Dallas, Texas. Contact Hollis at 800-752-4628 or ehollis@almfirst.com. Margot Strong, director of business development, may be reached at mstrong@almfirst.com.