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.

Posted at 6:31 pm IST on Tue, 8 Aug 2006         permanent link

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