Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Binary options on the Fed Funds Target Rate

Many exotic options leave one wondering whether they serve any real
purpose other than producing fat margins for the investment banks that
manufacture them. Binary options on the Fed funds target are an
interesting exception where there is a clear rationale for
a binary rather than a vanilla option.

Every six weeks, the US Federal Reserve (Fed) meets to decide on changes
to its monetary policy. The key instrument that the Fed uses is the
Fed Funds target. This is essentially a target that the Fed sets for
the overnight inter bank interest rate. The Fed supplies or withdraws
liquidity from the market so as to ensure that the interest rate on
Fed funds does not deviate by more than a few basis points from the
target set by it. In the bad old days, the Fed did not announce this
target but left it to be inferred by market participants from the
behaviour of the Fed. However, for several years now, the Fed
annnouces this target explicitly at the end of each meeting.

Most hedging activity related to the Fed funds target happens in
the Fed Funds Futures market which trades monthly contracts that
settle using the average Fed funds rate in that month. The difficulty
is that since the Fed Comitttee meets once in six weeks, this
meeting will often happen in the middle of the month. Fed funds target
changes will also happen mid way through the month. Ignoring the
differences between the actual Fed funds rate and its target, the
settlement rate for the monthly Fed funds contract will then be close to
the weighted average of the old target rate and the new target
rate. It will not be exactly equal to this weighted average because of
the slight deviation of a few basis points between actual and target rates.

All this is very messy compared to the CBOT’s Binary
Options on the Target Federal Funds Rate
. These binary call and
put options are available for the next four Fed Comitttee meetings at strikes
ranging from 250
basis points below the current target to 250 basis points above the
target at intervals of 12.5 basis points. The payout is $1,000 if the option
expires in-the-money, and $0 if it does not.

Though this contract was launched only a month ago, it has picked
up a tiny but fast growing open interest (less than 3,000 contracts
compared to over 0.5 million contracts on vanilla Fed fund options). The
Financial Times has an interesting
report
.

For those who use Fed Fund derivatives to hedge Fed fund interest
rate risk itself, the binary offers nothing truly exciting, but for
those who treat changes in the Fed Fund target as a driver of risk
appetite in other markets, the binary clearly makes a lot of
sense. For example, if you believe that a change in the target rate
impacts emerging market bonds or equities, then the binary is the
right hedging tool.

The usual arguments about discontinuous and unhedgeable Greeks of
binary options do not apply in this case because the discontinuity is
characteristic of the risk being hedged.

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