Federal funds futures: A barometer of interest rate expectations

color=#008000>Federal funds futures: A barometer of interest rate
expectations

Clearly, traders and investors have varying
opinions as to the future course of interest rates. There’s an easy way to see
exactly what the market as a whole expects. And once you learn how to read it,
it will only take you a couple of minutes to do it. This way you can see whether
your expectations are in line with the rest of the market.

color=#008000>What is the Federal Funds rate?
This rate is the one
charged by banks with excess cash to other banks needing overnight loans to meet
reserve requirements set by the government. This rate is the most accurate gauge
of interest rate expectations since it’s set daily by the market.

color=#008000>How is the contract constructed?
The futures
contract has an actively- traded contract for every month of the year. The
contract is for $5,000,000 and is based on a figure of 100 being equal to the
average fed funds rate for that month. The fed funds rate is published every
business day by the Federal Reserve Bank of New York. 

color=#008000>A Current Example
If we look at where the contract
for the month of February 2000 is trading on Dec. 22, 1999, we see that the
price is 94.235. This implies that at the end of February 2000 the market
expects the rate to be at 5.765% (100 — 94.235 = 5.765). Currently, the fed
funds rate is 5.50%. This implies that the market thinks that by the end of
February the Federal Reserve will raise the Federal Funds rate by 0.265% (5.765 —
5.50). We also know that on Feb. 1 the Federal Reserve will meet again to review
interest rate policy and so it’s expected that they’ll raise rates when they
meet at that time.