2.2.3. Federal Funds Futures
Banks in the U.S. are required to keep a certain amount of cash in reserve to protect their customers’ depository accounts, either in their own vaults or at the nearest Federal Reserve Bank. Reserves held in excess of these requirements may be lent overnight to banks with insufficient reserves. Excess reserves that banks lend in the overnight market to other banks are called federal funds.
Federal funds are lent at a very low interest rate called the federal funds rate. This rate is usually lower than the Federal Reserve’s discount rate, which is what the Federal Reserve charges banks to borrow money on a short-term basis. By setting the discount rate higher than the federal funds rate, the Federal Reserve encourages banks to borrow from each other, rather than the federal government, except as a last resort.
The 30-day federal funds futures contract has a notional value of $5 million, spanning anywhere from the current month to 36 months in the future. Its price represents the market’s opinion of what the average overnight federal funds rate will be for the delivery month. These contracts are cash settled on the last business day of the month. Prices are quoted at 100 minus the overnight federal funds rate for the delivery month. The tick size is one-half of one basis point, and the minimum tick is $20.835.
Note: Remember that the tick value for short-term interest rate futures must be adjusted for the term of the contract. With federal funds this is 30 days. The tick value, then, is the contract size of $5 million multiplied by the minimum tick of 0.005 basis points (0.00005) divided by 12 months. The result of $20.833 is rounded up to the nearest half penny to get $20.835. A basis point represents 1% (0.0001) of an annual interest rate.
As an instrument of the Federal Reserve, the federal funds rate is closely correlated with other short-term interest rates. This makes the federal funds futures contract