Why would one use options on a fed funds futures contract to estimate market expectations of alternative target rates instead of just the underlying futures contract?
This is best illustrated by example. As described in Q3, on October 31, 2005 the expected value of the target fed funds rate chosen at the January 2006 FOMC meeting should have been approximately 4.45%. This is consistent with a market perception 80% probability of the FOMC choosing a target 4.50% and a 20% probability of choosing 4.25%. However if a priori, 4.00%, 4.25%, 4.50% and 4.75% were considered plausible target rates, than both of the following scenarios are consistent with an expected target rate of 4.45% chosen at the January meeting. Scenario 1 Target rate chosen at January 2006 FOMC meeting Hypothetical probability on October 31, 2005 4.00% 0% 4.25% 20% 4.50% 80% 4.75% 0% Scenario 2 Target rate chosen at January 2006 FOMC meeting Hypothetical probability on October 31, 2005 4.00% 10% 4.25% 15% 4.50% 60% 4.75% 15% The February 2006 futures price cannot give any insight about which of these two scenarios is a better characterization of market expectations. But the options wr
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