Wednesday, June 24, 2009

Note on fed funds futures: target rate vs. effective rate

Not everyone realizes this, but so-called fed funds futures are not based directly on the official FOMC target rate, but rather are based on the average daily fed funds rate for the futures contract month, as reported by the NY Fed. As per, the contract specification for 30-Day Federal Funds Futures (which you can read, but is "locked" so that I can't copy and paste it!) the contract grade (final price to compare the contract price to for cash settlement) is calculated as the simple average of the daily Fed Funds overnight rate from the NY Fed for each day of the month. For weekend days and holidays you use the reported rate for the previous business day.

The NY Fed has a web page entitled Federal Funds Rate Data that is updated every business day morning. The second column in the main table is labeled DAILY with a footnote that says "The daily effective federal funds rate is a volume-weighted average of rates on trades arranged by major brokers. The effective rate is calculated by the Federal Reserve Bank of New York using data provided by the brokers and is subject to revision." The last column of the table gives the target rate, which might be a range. It is that second column, not the last column that is used in calculation of the fed funds futures settlement price.

So, even if the Fed FOMC makes no change to the target rate in a given month, the final average effective daily rate is inherently unpredictable. The daily rate at the beginning of June was 0.21%. It got as low as 0.14% as recent as June 12. Yesterday it was 0.24%. On Friday it was 0.25%.

The importance of all of this is that all of these futures-driven forecasts of the target rate that give probabilities are in fact based on the volatile effective daily rate.

Some people may use the fed funds futures prices for these forecast calculations, but at the end of the month there are real traders (and speculators) who depend on the actual hard-core effective daily rate to determine their profit and loss for their "investment" in the futures contracts. Probability forecasts do not figure in their final calculations.

Granted, the effective daily rate does tend to average near the target rate, especially if the NY Fed is successful at doing its job of open market operations, but there can be times when there is significant variation of the effective rate from the target rate.

Regardless of what the FOMC decides today, only the open market transactions of the NY Fed will determine the effective daily rate for the remaining days of June and hence the average for the full month.

-- Jack Krupansky

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