Heads or tails? Those following the debate over the Federal Reserve’s decision on interest rates, due today, know that the arguments for and against a further rate rise have been anything but black and white.
Yet the Chicago Board of Trade’s new binary options on Fed funds target rates reduce it to just that; a win or lose, all-or-nothing, bet.
Interest rate risk is one of the single biggest risks affecting all investors and money managers. A growing array of potential hedging tools have been developed to enable the isolation and transfer of that risk.
Today’s Federal Open Market Committee meeting is the first since the new binaries were launched last month and it will prove an interesting test for users. With the Fed on a steady path of successive quarter-point rate rises for the past two years, market expectations have usually settled well in advance of the meeting. This time, however, investors’ bets on the outcome have swung wildly, veering all the way from virtually no chance to a near certainty and almost all the way back again.
Binaries are the latest addition to an existing universe of interest rate derivatives, including the CBOT’s Fed funds futures, the Chicago Mercantile Exchange’s eurodollar futures and related instruments.
“Our research indicated that there would be strong demand for a contract that offers direct exposure to the target federal funds rate, and after only 18 trading days, that’s certainly playing out,” said Craig Grabiner, a spokesman for the CBOT.
He said open interest in the binaries rose to 1,000 contracts within eight days, one of the quickest starts for a new CBOT contract, and has risen to more than 2,700.
Binary contracts are in use elsewhere, notably on Hedgestreet.com. But their application in large-scale interest rate hedging underlines how diverse the derivatives world is becoming as investors seek ever more specific tools to deal with very particular risks.
“It’s clear that any market professional trading at the front [short-term] end, or using financing, would be interested in using binary options to hedge positions,” said Eric Liverance, strategist at Morgan Stanley, in a research note that outlined various strategies for using the instruments.
Unlike traditional options where the intrinsic value of the contract varies with the difference between the strike price and the market price, binaries either pay out a set sum – $1,000 per contract in the case of Fed fund binaries – or nothing at all.
For traders this can count as a low risk proposition, since users know in advance exactly what they stand to gain or lose.
“Will these ever replace the original Fed funds futures and options complex? Not likely, but they will undoubtedly supplement it,” said David Boberski, interest rate strategist at Bear Stearns.
Fed funds futures are settled using the average effective Fed funds rate for a given month, which often varies slightly from the target rate announced by the central bank. By contrast, binaries pay out based on that target, meaning traders’ bets are “cleaner”, or less likely to be influenced by other market action.
Strike prices on the options are based on the same principles as pricing for more traditional Fed funds futures. In this case, that is 100 minus the target rate. At the current rate of 5.25 per cent, the at-the-money strike price is therefore 94.75.
There is one contract for each scheduled Fed meeting, and each stops trading 15 minutes before that particular Fed decision is due (2.15pm, Eastern Standard Time) and are settled at 5pm EST that day based on the Fed’s newly announced rate.
Investors can buy calls or sell puts. Calls will be in-the-money, or pay out, when the strike price is below the target rate at expiration. Puts will be in-the-money when the strike is higher than the target.
For example, if the at-the-money strike price is 94.75, a quarter-point rate cut to 5 per cent would take the target rate at expiration to 95.00. Calls bought at 94.75 would therefore collect the $1,000 payout. If the Fed holds rates steady at 5.25 per cent, those same contracts would expire worthless.
Puts are the opposite, meaning an investor who thought rates could rise a quarter-point from the current 5.25 per cent would buy a put at 94.75 with the aiming of collecting the $1,000 when the target rate changed to 94.50. Again, if the Fed left rates unchanged, the payout would be zero.
Additional reporting by Richard Beales
This is the fourth in a series on capital markets innovations. View the others in the series at www.ft.com/wizardry
