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Econbrowser on Pricing of interest rate risk in fed funds futures contracts

Do current fed funds futures prices signal a belief by market participants that the Fed may begin raising interest rates early next year? My latest research paper suggests not.

The expectations hypothesis of the term structure of interest rates posits that an investor could expect to receive the same return from buying a 6-month T-bill as from rolling over two 3-month T-bills. Although this is an appealing hypothesis, it has been consistently rejected by empirical researchers, including Campbell and Shiller (1991), Evans and Lewis (1994), Bekaert, Hodrick and Marshall (1997), and Cochrane and Piazzesi (2005) among many others. What that literature has shown is that when the 6-month yield is higher than the 3-month, on average you'd do better with it than with rolling over the 3-months. Typically the term structure slopes up, and typically you earn a higher return from longer term securities.

In a new paper coauthored with Hitotsubashi University Professor Tatsuyoshi Okimoto, we show that arbitrage should force the predictable excess returns on bonds of longer maturities to show up as predictable gains from taking the long position in fed funds futures contracts. The average upward slope to the term structure of interest rates should imply an average upward slope to the interest rates associated with fed funds contracts of increasing maturity. One might then want to adjust these futures rates to obtain an unbiased market expectation, as suggested in a recent paper by Piazzesi and Swanson.

Professor Okimoto and I also investigate the potential predictability of holding gains from long positions in fed funds futures contracts. We find mixed evidence for predictability for the most near-term contracts, but persuasive indications of predictability for contracts beyond 4 months. One of the interesting features we document is that this predictability over the 1991-2006 period appears to be mostly due to a few particular episodes characterized by a weak economy and unusually volatile interest rates. We model returns as shifting in and out of this predictable regime, with our assessment of how likely it is that one could earn an expected profit from taking the long position on a 6-month contract indicated in the graph below. These episodes of predictable gains are characterized by weak employment growth and unusual volatility of interest rates.

Posted via web from Jim Nichols