Using Fed Funds Futures Contracts

Participants in the fed funds futures market need not be banks that borrow in the fed funds market. Anyone who can satisfy margin requirements may participate. Thus, traders who make their living as Fed-watchers may speculate with fed funds futures. This would suggest that to the extent Fed policy is predictable, speculators would drive futures prices to embody expectations of future policy actions. Because the level of the fed funds rate is essentially determined by deliberative policy decisions, the fed funds futures rate should have predictable value for the size and timing of future policy actions.

Given that the Trading Desk may face systematic problems that hinder its ability to achieve its objective, the consequences for the funds rate may be predictable. Speculators who anticipate such effects may find it profitable to buy or sell current contracts.

In the case of fed funds, the rate is essentially determined by a deliberative FOMC decision. Hence, the fed funds futures markets must anticipate the FOMC's actions. In short, through the fed funds futures markets, one can place a bet on what future monetary policy will be. The committee then can get a clear reading of what these market participants expect them to do, which may at times be helpful for FOMC members who place great weight on knowing if a policy choice would surprise the market.

If fed funds rates are to be instructive for policymakers, they should have some predictive content. The predictive accuracy of futures rates historically improves over the two-month period leading up to the contract's expiration, providing some evidence that the market is efficient in incorporating new information into its pricing. The largest prediction errors have occurred around policy turning points. Nevertheless, there is a lot of evidence to suggest that the fed funds futures markets are efficient processors of information concerning the future path of the fed funds rate.

Happy trading.