What it means
Each contract settles against the average effective federal funds rate for a calendar month, and it is quoted as 100 minus that rate. A price of 95.25 therefore implies an average overnight rate of 4.75% for the month in question.
Contracts trade for many months ahead, so the whole strip of prices maps out the market's expected path for interest rates. This matters well outside trading desks.
Corporate treasurers use the implied path to decide whether to fix or float on a new borrowing facility, and finance directors use it as the interest assumption inside budgets and covenant forecasts. It is a forecast built out of money at risk, which usually makes it more honest than a published opinion.
The practical use is converting prices into probabilities of a specific policy decision. If the current target rate is known and the market prices an expected rate somewhere between the current level and the level implied by a 25 basis point move, the distance between them gives the implied probability of that move.
Financial news services publish these probabilities daily, and they move sharply after inflation and employment releases. There are two traps for the unwary.
Because settlement is on the monthly average, a contract covering a month with a meeting halfway through blends the old and new rates, so the calculation must weight the days before and after the decision. An implied probability is also not a forecast of what should happen; it is a snapshot of current positioning that can change within minutes.
A closely related instrument, the overnight index swap, does much the same job over custom periods and is more common outside the United States. Traders arbitrage between the two, so the implied rate paths they produce rarely diverge by much.
In practice
Real-world examples.
Example
A manufacturer is about to draw $80,000,000 on a floating rate facility. Its treasurer sees fed funds futures pricing three cuts over the next year, decides the floating cost is likely to fall, and chooses not to pay for an interest rate swap.
Example
A commercial property investor building a five-year cash flow model uses the futures strip for the first eight quarters of interest assumptions, then reverts to a long-run average. The auditors accept the approach because the inputs are observable market prices rather than internal opinion.
Example
A bank's economics team publishes a client note the morning after an inflation release. The note leads with the change in implied probability of a cut at the next meeting, which moved from 65% to 20% within ten minutes of the data.
Formula
Calculation
Implied average rate = 100 - Futures price
Probability of a move = (Implied rate - Current rate) / (Rate after the move - Current rate)
The current target rate is 4.50%. A contract covering a month in which the whole period would sit at any new rate trades at 95.40, so the implied average rate is 100 - 95.40 = 4.60%.
If the only realistic outcomes are no change at 4.50% or a 25 basis point rise to 4.75%, the implied probability of the rise is (4.60% - 4.50%) / (4.75% - 4.50%) = 0.10 / 0.25 = 40%. In other words the market is pricing a 40% chance of a rise and a 60% chance of no change.
Each contract covers $5,000,000 of notional for a 30-day month, so one basis point is worth $5,000,000 x 0.0001 x (30 / 360) = $41.67. A treasurer hedging with 20 contracts therefore gains or loses roughly $41.67 x 10 x 20 = $8,334 for every 10 basis point shift in the implied rate.Case study
Seen in the real world.
The following is a fictional, illustrative case. Halvern Foods, an invented food processing group, carried $150,000,000 of floating rate debt and was preparing its annual budget. Its board wanted a single interest expense number, and the two obvious candidates were the current rate of 5.25% and the chief economist's forecast of 3.75% by year end.
The treasury team took a third route and built the assumption from the futures strip, which implied an average rate of about 4.60% across the coming twelve months. That translated to a budgeted interest cost of $150,000,000 x 4.60% = $6,900,000, against $7,875,000 at the current rate and $5,625,000 at the economist's forecast.
Actual rates fell more slowly than the strip implied, and interest expense came in at $7,050,000, a variance of $150,000 or about 2%. The illustrative point is not that the futures market predicted the year correctly, but that it gave Halvern a neutral, defensible and easily explained assumption, and one the finance director could update every month without renegotiating the forecast.
Watch out
Common mistakes.
- Reading an implied probability as a forecast. It is a price, reflecting how traders are positioned right now, and it can swing by 40 percentage points on a single data release.
- Forgetting that settlement is on the monthly average. For a month containing a mid-month meeting, the implied rate blends the old and new levels and must be weighted by days.
- Assuming the implied path is unbiased. Futures prices contain a small risk premium, so they are not a pure expectation of future rates.
Questions
People also ask.
What does a futures price of 96.75 mean?
An implied average federal funds rate of 100 - 96.75 = 3.25% for the contract month.
How is this different from an overnight index swap?
Both express expectations for overnight rates, but the swap is an over-the-counter contract over any chosen period, while the future is exchange-traded on standard monthly terms.
Should a business hedge using these contracts directly?
Rarely, because the standard contract size and monthly averaging suit financial institutions; most companies achieve the same effect through an interest rate swap or cap arranged by their bank.
From the founder's library
Take it further with the book.
Build your financial confidence beyond this definition. Shihan's full-length guide, Accounting Fundamentals, takes the same plain-English approach and turns it into a complete, practical playbook for non-finance managers, business owners and students - with chapter-end quiz answers and presentation slides included.
25% off with code MMHQ25, applied at checkout. Priced in USD - checkout may show the equivalent in your local currency.
View the book and save 25%