Using Options to Understand Fed Behavior
A CME Webinar with William Melnick ISSUE 704 | APRIL 2008
Speculation about where interest rates are going accelerates heading into each Federal Reserve policy meeting, and you can trade your own view using CME Fed funds futures, options, and binary contracts.
In a live CME webinar on April 24, 2008, William Melnick, Gensemer Professor of Economics at Kenyon College and research associate with Federal Reserve Bank of Cleveland, presented an overview of the differences between CME Fed funds futures, options on Fed funds futures, and binary Fed funds options contracts, and how to trade them. The Fed funds rate is the key short-term, inter-bank lending rate under the Fed's control. See webinar archive here.
CME Fed funds futures allows speculators to take positions based on their view on interest rates, and large institutions can hedge rate against rate changes that might be detrimental to their business interests.
There are three vehicles to trade the Fed funds rate at CME Group: Fed funds futures, options on Fed funds futures, and the newest addition, Fed binary options. While binaries are the "new kid on the block," Melnick said they offer unique advantages for hedging and speculating that are worth considering.
All three contracts are priced according to market views of potential Federal funds rate changes at the outcome of FOMC meetings. The 30-day Fed funds futures track the effective overnight Federal funds rate for a specific month. Melnick said the options on the futures allow for a more precise fine-tuning of that rate speculation, and also offer a trading vehicle with defined risk. The binary contract is focused on the target Fed funds rate, and offers just two outcomes (win or lose) with a defined risk and reward for both the buyer and the seller. There is a payout of $1,000 (the buyer receives and the seller pays) if the option expires in-the-money, and $0 if it does not.
In this webinar, Melnick focused mainly on the Fed funds options contracts.
Why Options?
Melnick outlined some of the limitations of the 30-day Fed funds futures contract, and why you might consider regular or binary options. He said a single futures contract price in a given month won't allow for a complete understanding of the risks and pricing for an upcoming FOMC meeting, unless all participants believe the FOMC will choose from just two possible rate targets. That's not always a valid assumption, especially in unsettled times. There may be a divergence of opinions about FOMC target rates.
It's harder with futures to customize a position, because you only have a single futures price, but options offer different strike prices and therefore a wider range of rate probabilities to choose from, said Melnick.
He gave an example looking at implied probabilities taken from the May 2008 Fed funds futures contract on April 17. On that day, the futures were trading at 98.05, which imply a Fed funds rate of 1.955. Then on April 18, the futures price fell to 97.955, indicating participants saw a greater chance the rate would be higher. With futures, you are restricted to probabilities based on only two rate outcomes. On April 17, the two rate outcomes were 1.75 percent, or 2 percent. Then when the futures price fell the next day, the two outcomes were 2 percent or 2.25 percent. Melnick said the question comes to mind whether it was really the case that no one on April 17 was thinking a 2.25 percent rate was likely, and the next day, no one was thinking 1.75 was likely. In essence, Melnick said futures can't capture all the nuances of what's going on, and that's where options might help.
As Fed funds options involve a variety of strike prices, he said you get a better ability to understand market views about future rate changes, and a better way to position yourself ahead of those rate decisions. Prices at different strikes can be used to trace out the full range of market expectations for an upcoming FOMC meeting. Melnick offered an example for the upcoming meeting looking at different options prices. A put priced at 98.375 translates into a call with an interest rate of 1.625 percent. In the table below, the first column shows that option would be in the money if the FOMC chooses a target rate of 1.75 percent, 2 percent, or 2.25 percent. You can see the scenarios for other possible option strikes.
| Target Fed Funds rate for April 30 FOMC meeting | |||
| 98.375 put (1.625 call) | 98.125 put (1.875 call) | 97.875 put (2.125 call) | |
| 1.75 | in the money | out of the money | out of the money |
| 2.0 | in the money | in the money | out of the money |
| 2.25 | in the money | in the money | in the money |
By using these three options and their prices, you can get a better understanding of the likelihood of these target rate choices than you could by looking at a single futures price. Each options price should equal the probability weighted value of the payoffs under all possible target rate choices the FOMC might make. The FOMC usually chooses from only a handful of possible target rates, separated by 25 basis point increments.
The graphic below shows FOMC rate probabilities using settlement prices on April 23, 2008. The magenta bars represent probabilities recovered from a single futures price, while the blue bars represent probabilities from all available options prices from the May contract. Melnick said you can see a richer picture when you look at options. Options show a small chance the FOMC could cut by 50 basis points, while the futures are constrained to two possible targets, 2.0 and 2.25 percent. If you were to look at a meeting farther out in time, Melnick said you get an even richer picture. At the time of this webinar, the FOMC meeting was just days away, and views had been largely cemented.
The Cleveland Federal Reserve Bank also does its own probability calculations, listed on its Web site. A sample of one of the calculations is illustrated below. Melnick said they are consistent with what we've seen in the futures and options markets--the bulk of the mass is at 2 percent; other rates seem less likely for the Fed to target.
Problems Using Fed Funds Options
Melnick said there is an art to choosing how much structure to impose on the possible FOMC target choices. The more rate choices you give the FOMC, the more options you will need to try and recover those probabilities. The available options will somewhat limit the choices you can consider. For example, if you don't have an option with a strike price above 99, implying a rate below 1 percent, you can't trade the possibility the Fed will cut rates to that level, he said. Also, you have to keep in mind that CME options are American style, and a sophisticated examination or analysis would take an early exercise possibility into account.
There is also what Melnick called "dirty months" to consider. If FOMC meets near the end of a month, such as the June 25 policy meeting, that means looking at the June contract, only the last five days of the contract's monthly average will be affected by the Fed's June FOMC decision. It will be more difficult to look at June options prices to make a strong statement about what the FOMC will do in June. The bulk of the month's average is the 24 days prior to the meeting; those will have the biggest impact.
April options are even worse, given the meeting's conclusion is April 30. If you tried to use April options to talk about the April meeting, you'll only have one day that choice will make a difference, Melnick said.
A "clean month" would be one with no meeting, such as May. Every day in May will tell you something about the choice made you made in April, he said. That's also the case in July; every day in July will tell you about the choice made in June.
Also, as mentioned, the options on Fed funds futures are based on the effective rate. For whatever reason, the FOMC's trading desk may have difficulty hitting their exact target rate. The difference (target rate vs. effective rate) could be variable and hard to model, especially if the effective rate starts moving before the FOMC meeting ends in anticipation of a change. That could complicate any analysis you will do.
Fed Funds Binary Options
The binary options contracts account for this problem, as they are based on the target rate, not the effective rate. They are priced at different strikes, and like the options on the Fed funds futures, can be used to trace out the full range of market expectations for an upcoming meeting. You don't have to worry about dirty months, or how many days in the month come before or after the FOMC meeting, said Melnick.
In contrast to the straight options, however, there are only two payouts for binaries at expiration: $0 or $1,000. You are either in the money and get $1,000, or are out of the money and get nothing. It does not matter how far the option is in the money. Par is 100 points for the contract, and a contract pays $1,000 if you are in the money. So, one price point equals $10. Price is always between one and 100, so the price is interpreted as a cumulative probability of being above or below the options price.
For example, Melnick said if a call has strike of 98.125 and is priced at 15, the call pays off for you if 100-target rate (TR) is greater than 98.125.
Translated into rates, 100-TR is greater than 98.125, so the payoff comes when the target rate is below 1.875. The 98.125 call can be thought of as a put with a strike of 1.875. The put pays off if the target falls below 1.875. The FOMC could chose 1.75, and you get the payoff, Melnick said. A price of 15 means there is a 15 percent chance that the target rate will be below the strike price, expressed as an interest rate. Remember, the payoff is either $1,000 or zero, it doesn't depend on how much the option is in the money.
Below is a graphic similar to the one we saw before comparing futures and options, but now with binaries added in yellow. You see a close correspondence between options and binaries.
Melnick said in his research he sees a close correlation between the options on the futures and binary options. The options might be telling you the probability of a target rate of 2 is 50 percent, for example, and the binaries show 53 percent.
Trading Application
Melnick offered a practical application for an institutional user of this market. Suppose you want to fund a $700 million fixed income portfolio in the 90-day repo market. You are convinced the FOMC will lower the Fed funds rate to 2 percent in April, but you feel they will have to start raising rates soon because of rising inflation. You think that by the August 8 FOMC meeting, the target rate will be 2.50 percent. Even though you have locked in funding at 1.7, you may have to pay a lot more to fund that portfolio if your fears about rising rates are realized.
During the last tightening cycle, Melnick said the 90-day repo rate was 10 basis points above the overnight Fed funds. So if the FOMC moves the rate up to 2.5 percent, the 90-day repo rate would move to 2.60 percent. Your cost of funding your portfolio for 90 days goes to $4.55 million (700 x 0.026)/4 from $2.975 million (700 x 0.017)/4.
What can you do? Melnick said perhaps you use an August binary 97.625 put, which is equivalent to a 2.375 call in terms of the interest rate. If your fears are realized (the Fed funds rate moves to 2.50 percent), it finishes in the money.
Suppose the August 97.625 put has a price of 15, so it costs $150, and pays $1,000. Your net is $850 on a contract. To cover your exposure, you would need 1,853 contracts ($1.575 million/$850).
So you are paying $277,950 (1853 x 150) to cover your $1.575 million exposure. Of course, insurance will cost you, but Melnick said this market offers you a way to essentially lock in the 1.86 percent funding cost, an effective hedge. He notes that this is just a hypothetical example. He just picked an arbitrary price of 15, it could be more or less and therefore your costs might change.
Melnick said options on futures and binary Fed funds options offer clear advantages in understanding future FOMC target rate changes and positioning with regard to those changes.
Stay tuned for the meeting on April 30, and try trading your view with Lind-Waldock!
For more information on Fed funds futures, options, and binaries, visit www.cmegroup.com. Click here to view a full archived video recording of this CME Group Webinar.
Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email at editor@lind-waldock.com.
Futures trading involves substantial risk of loss and is not suitable for all investors.
Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
© 2008 MF Global Ltd. All Rights Reserved.
