options on federal funds futures and interest rate volatility

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  • I am grateful to an anonymous referee, Vaishnavi Bhatt, David Gulley, David Nanigian, Kuldeep Shastri,David Simon, and the editor, Robert Webb, for helpful suggestions. I also thank the CME Group for provid-ing data on the volume of fed funds options. I am responsible for all remaining errors.

    *Correspondence author, Department of Finance, Bentley University, 175 Forest Street, Waltham, MA02154-4705. e-mail: jsultan@bentley.edu

    Received May 2008; Accepted February 2011

    Jahangir Sultan is a Professor of Finance and the Founding Director of the Hughey Center forFinancial Services, Bentley University, Waltham, Massachusetts.

    2011 Wiley Periodicals, Inc.

    DOI: 10.1002/fut.20524



    This study examines the response of the spot and futures interest rates on the fedfunds, Eurodollar, and Libor to the listing of CME fed funds options. With theexception of the Libor futures, the introduction of options is associated with adecrease in the conditional volatility of the interest rates in the sample. There isalso evidence that the volume of options trading has a negative effect on the fedfunds and the Eurodollar spot rates. In contrast, the fed funds and the Eurodollarfutures rates respond positively to the volume of options trading. Overall, stronggeneralization of the effects of options listing and options trading across the mar-kets is not possible. These results remain robust even after controlling for severalexogenous variables including changes in the Feds target for the fed funds rate,the TED spread, the 9/11 terrorist attacks, and day-of-the-week effects. 2011


    The CME options on fed funds futures (ticker symbols FFC (call) and FFP(put)) are American options for one unit of fed funds futures. First introduced

    Published online April 14, 2011 in Wiley Online Library (wileyonlinelibrary.com).

    The Journal of Futures Markets, Vol. 32, No. 4, 330359 (2012)

    Wiley Periodicals, Inc. Jrl Fut Mark 32:330359, 2012

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    Journal of Futures Markets DOI: 10.1002/fut

    on March 14, 2003, monthly contracts are available for up to two years.1 Boththe fed funds futures and options allow market participants to track the marketsexpectations of monetary policy by the FOMC. To quote the CME, Perhaps nosingle financial policy carries more weight than the fed funds target.Consequently, in the weeks preceding an FOMC meeting, the fed fundsfutures and options contracts attract attention from all corners of the nancialworld.2 As of today, the effects of the introduction of fed funds options on theprimary markets have not been discussed in the literature.

    This study examines the response of the level and volatility of the spot andfutures interest rates on the fed funds, Eurodollar, and the Libor to the intro-duction of options on CME fed funds futures. A key result in the study is thatoptions listing is associated with a decrease in the conditional volatility of theinterest rates, with the exception of the Libor futures. In addition, the effect ofoptions trading volume on the volatility of spot interest rates (fed funds andEurodollar) is negative, implying that options stabilize the primary markets.These results suggest that the CME fed funds options offer additional informa-tion on monetary policy and thus resolve uncertainty in the spot market. Incontrast, trading on options leads to higher volatility in the futures markets (fedfunds and the Eurodollar), implying that options on fed funds futures destabi-lize close substitutes. This is consistent with the notion that if written optionsare hedged in the futures market, it has the potential to raise volatility in themarket. Overall, these results remain robust even after controlling for severalexogenous variables including changes in the Feds target for the fed funds, theTED spread, and day-of-the-week effects. Furthermore, these results are alsorobust to unexpected shocks including the 9/11 terrorist attacks and the recentcredit crisis.

    The study is organized as follows. Section 2 reports on the trading activityon the CME options on fed funds futures. Section 3 reviews the literature anddiscusses the hypothesis. Section 4 offers the empirical results. The nal sec-tion has concluding remarks.


    An American style call option on the CME fed funds futures gives the buyer theright to establish a long position in the fed funds futures. Therefore, if one expects the Fed to raise (lower) the target fed funds rate, then a protable strategy

    1The minimum tick size is one quarter basis point which is equivalent to $10.4175. According to the CME,the monthly (November 2009) volume was 463,670 contracts, which was 5.2% higher than the previous yearvalue for the month. Prior to the merger between the CBOT and CME, options on fed funds futures tradedon the CBOT.2Source: 30-day Federal funds Futures and Options, CME Group. http://www.cmegroup.com/trading/interest-rates/les/IR-143_FEDFUNDSFC_lo-res_web.pdf, accessed on September 22, 2009.

    331Federal Funds Futures and Interest Rate Volatility

    Journal of Futures Markets DOI: 10.1002/fut

  • Federal Funds Futures and Interest Rate Volatility 3

    Journal of Futures Markets DOI: 10.1002/fut

    would be to buy a put (call) option. The strike prices are set around the previ-ous days closing price for the futures contract. So, there would be 21 strikeprices around the closing price at 6.25 basis point intervals. In addition, therewould be 10 more strike prices outside of the band (5 increments of 12.50basis points above the fed funds futures price and 5 decrements of 12.50 basispoints below the fed funds futures price). Options are quoted with a quarterbasis point tick size, which is worth $10.4175.

    The underlying instrument for the CME fed funds options is the CME 30-day fed funds futures contract which is a contract for the delivery of theinterest paid on $5 million overnight fed funds held for 30 days. The futurescontract is cash settled against the average of the daily fed funds effective ratesfor the delivery month. Since their introduction, these contracts have becomepopular for hedging, speculation, as well as for predicting Fed policy outcomes.As Carlson, Melick, and Sahinoz (2003) claim, the fed funds futures rate is based upon a deliberative policy outcomes of the Fed because on averagethe fed funds rate moves with the target fed funds rate. Since the target fedfunds rate is effectively managed by the actions of the FOMC, the fed fundsfutures contracts provide quite a reasonable estimates of the policy outcomeson average.

    It is critical to note that the fed funds futures contracts offer market participants only two outcomes, the probability of a rate increase and the prob-ability of a rate cut. Therefore, a single futures contract cannot adequately cap-ture the entire distribution of expectations about the target path of the fedfunds rate. With the introduction of CME fed funds options on March 14,2003, options prices at different strike prices offer market participants an addi-tional tool to survey varying market expectations regarding monetary policystance. According to Carlson, Craig, and Melick (2005), if market participantshave a wide range of expectations on the next policy outcomes, the fed fundsoptions prices can adequately incorporate such expectations. The authors showthat options prices at different strike prices and for different maturities can beutilized to capture the probability density function for the target path of the fedfunds rate.

    Daily data on volume and open interest on options for the period12/1/2003 to 5/29/2009 are obtained from the CME group. The daily averagevolume for call options for the period is 15,693 contracts with a standard devi-ation of 16,825 contracts. The average open interest on call options are450,491 with a standard deviation of 223,544 contracts. For put options, thedaily average volume for the period is 10,945 contracts with a standard devia-tion of 13,427 contracts. The average open interest on put options is 338,863contracts with a standard deviation of 169,171 contracts. Finally, daily averagevolume (call plus put volume) is 26,638 contracts, with a standard deviation of

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    Journal of Futures Markets DOI: 10.1002/fut

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    Journal of Futures Markets DOI: 10.1002/fut

    24,621 contracts. The daily average open interest is 789,355 contracts and thestandard deviation is 342,074 contracts.

    In Figures 1 and 2, daily options volumes are plotted against the fed fundsspot rate. As Figure 1 illustrates, the volume of calls fluctuated during theentire period, rising to a record level of 208,637 contracts on October 31,2007. Interestingly, this was also the period when interest rates gradually start-ed to decline, perhaps in response to the massive liquidity injections by the Fedand other monetary authorities to stave off the credit crisis. A declining interestrate would prompt buying call options on the fed funds futures as futuresprices are expected to rise.

    In contrast (Figure 2), trading on puts was more active trading on callsduring 20032006, although the average number of contracts traded was lowerthan call options. As interest rates were rising since 2004 and then stabilized inthe early summer of 2006, there was heavy trading on puts. This is expectedwhen rates rise, fed funds futures price is expected to fall, and buying putoptions on futures is protable. Trading on put options peaked on January 30,2008, when volume reached to a record level of 121,318 contracts.

    Overall, trading on CME options on fed funds futures is evolving. As options, futures, and spot instruments are combined for trading and risk






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