How can fed funds futures be used to gauge expectations of the federal funds rate?
This is best illustrated by example. On October 31, 2005, the fed funds futures contract with a February 2006 delivery date of had a settlement price of 95.55. Abstracting from transaction costs, a purchaser of this futures contract at this price would profit if and only if 100 minus February’s average effective fed funds ended up above 95.55. This would happen if February’s average effective fed funds ended up below 4.45%. Similarly, someone selling this futures contract at a price of 95.55 would profit if the average February effective fed funds ended up above 4.45%. Assuming risk neutrality, market expectations of the February 2006 fed funds rate should have been about 4.45% on average on October 31, 2005. If they were much higher, for example, market participants would have been willing to sell this contract at slightly below the prevailing price of 95.55 and expected to make a profit, thereby driving the futures price below what it was observed to have been. Changes in the fed fun
