The fed funds rate is the interest rate that banks pay when they borrow

Federal Reserve

deposits, usually overnight, from other banks. Financial market participants watch it closely, because the level of the funds rate can be immediately and purposefully affected by Federal Reserve open market operations.

The Federal Open Market Committee, the main policymaking arm of the Federal Reserve, communicates an objective for the fed funds rate in a directive to the Trading Desk at the Federal Reserve Bank of New York. Actions taken to change an intended level of the fed funds rate are motivated by a desire to accomplish ultimate policy objectives, especially price stability. Permanent changes in the fed funds rate level are thus the consequence of deliberate policy decisions.

The fed funds contract, also known as 30-day fed funds futures, calls for delivery of interest paid on a principal amount of $5 million in overnight fed funds. In practice, the total interest is not really paid but is cash-settled daily. This means payments are made whenever the futures contract settlement price changes.

The futures settlement price is calculated as 100 minus the monthly arithmetic average of the daily effective fed funds rate that the Trading Desk reports for each day of the contract month. Payments are made through margin accounts that sellers and holders have with their brokers. At the end of the trading day, sellers' and holders' accounts are debited or credited to facilitate payments.

Fed funds futures are a convenient tool for hedging against future interest rate changes. To illustrate, consider a regional bank that consistently buys $100 million in fed funds. Suppose the bank's analysts believe that economic data to be released in the upcoming week will induce the FOMC to increase the objective of the fed funds rate by 50 basis points at its next meeting.

If the contract settle price (for the meeting month) implies no change from the current rate, the bank may choose to lock in its current cost by selling 20 contracts (or taking a short position) and holding the position to expiration. Conversely, suppose that a net lender of funds expects a policy action to lower the fed funds rate. It can protect its return by buying futures contracts (or taking a long position).

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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.

By Jeff Neal, staff writer and options strategist at

Optionetics.com. Email him at

jeff@optionetics.com.