Fed funds also known as the federal funds, refers to the excess reserves of the central bank of the USA namely the Federal Reserve.
What is the fed fund rate?
All commercial banks and financial depository institutions are required to deposit and maintain reserves in the central bank.
The banks that have excess funds in their reserves, can in turn use the same to lend money to other banks and financial depository institutions that have insufficient cash in hand to meet their lending and reserve requirements.
The interest rate at which such loans are conducted is known as the federal fund rate. It is an unsecured loan with relatively low rate of interest as the duration for which the majority of such loans are made is overnight or on next day i.e. on T + 1 basis. Thus, this is also known as overnight rate.
The current fed funds rate is between 4.25% and 4.5% (December, 2022).
However, the banks involved in the transaction negotiate and decide on the rate of interest for each loan, which is what affects the calculation of EFFR.
What is the EFFR?
The EFFR refers to the Effective Fed Funds Rate which is calculated using a volume weighted average method by the FRBNY, namely the Federal Reserve Bank of New York. The FRBNY gathers transactional data on Fed Funds daily from participating banks, financial depository institutions and other intermediaries and then analyses this data in order to publish the EFFR on its website.
What are futures?
A futures contract is a standardised derivatives contract based on an underlying asset, between two parties to buy or sell; at a predetermined price and quantity on a specified date in the future.
What are fed fund futures?
Fed fund futures contracts are standardised derivatives contracts based on the EFFR, between two parties to buy or sell; at a predetermined price and quantity on a specified date in the future.
- They are traded on the Chicago Mercantile Exchange (CME).
- They are listed every month, extending up to 36 months or 3 years on the yield curve.
- The duration of each contract is 30 Days.
- The Contract Size is $5,000,000/Contract.
Fed fund futures pricing
Although fed fund futures are based on the EFFR, they are traded in IMM (International Monetary Market) index terms which means as a price rather than a rate.
Formula:
Fed fund futures price = 100 - Implied Rate.
For instance, if the average monthly Fed Funds rate for November is 2.30% the futures price would be 100 - 2.30 = 97.700.
How are fed fund futures settled?
- All fed fund futures are cash-settled.
- Fed fund futures are settled on the last trading day of the month.
- They are backward looking futures contracts.
- Final settlement calculation formula:
- Fed fund futures price at expiry= 100 - Fed fund rate at expiry; where
- Fed fund rate at expiry =
Sum total of all the daily EFFR rates published by the FRBNY
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Number of days in the month
Illustration
Let's use an example to gain a better understanding of fed fund futures.
Let's say there are 30 days in the fed futures contract for the month of November.
Sum total of all the daily EFFR rates published by the FRBNY = 102.600.
Final settlement calculation formula:
Fed fund rate at expiry =
Sum total of all the daily EFFR rates published by the FRBNY
-----------------------------------------------------
Number of days in the month
= 102.600 ÷ 30 = 3.420
Fed fund futures price at expiry= 100 - Fed fund rate at expiry=100 – 3.420 = 96.580.
Thus, 96.580 was the final settlement for the November Fed Funds futures contract
Factors that influence the fed funds and futures
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FOMC Meetings
The Federal Open Market Committee (FOMC) sets the Fed Fund target rate, the months when there is an FOMC meeting can be very important to contract pricing. But since most FOMC meetings occur mid-month, the first Fed Fund futures contract to be fully affected by a rate change would be the next deferred contract month, rather than the contract in which the meeting takes place.
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Inflation
It can be used to curb the level of inflation in the country:
- If the fed fund rate increases, it makes the borrowing of funds expensive which in turn decreases the supply of available money and increases the short-term interest rates.
- Whereas if the fed fund rate decreases, it makes the borrowing of funds less expensive which in turn increases the supply of available money and decreases the short-term interest rates.
- Other factors
Other factors such as employment statistics etc also has an effect on the fed funds rate and consequently fed fund futures.