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July 27, 2007
Trading in binary Fed options
After reading the latest GDP news, I went poking around the CBOT website to see how things were going on the futures market for fed funds. One thing caught my eye. Shortly before noon today, there was a posting of a trade of 500 Fed Binary Options for December 07. Specifically, they were call options with a strike price of 94750. The trade was completed at a price of 41 ($410 per contract). That is the only open interest on that contract so far.
Here's what this means. A long position in this contract receives $1000 per contract if the fed funds target is less than 5.25% (the prevailing rate today) on the day after the December 2007 FOMC meeting. Essentially, two parties were able to agree on a bet that effectively indicates a subjective probability of a rate cut by December at 41%.
In case you're interested, the latest prices for similar options maturing in August, September, and October are 9, 20, and 28 respectively.
The more traditional 30 day futures on fed funds were broadly higher as well, though yesterday's moves in light of the continued housing difficulties were larger. Today's GDP numbers seemed to reinforce yesterday's news. September contracts on the IEM have not started to move much yet. We'll keep in eye on that.
It will indeed be interesting to watch the binary options on the CBOT in the coming weeks. Keep it tuned right here for the coverage.
Posted by William Polley at July 27, 2007 03:54 PM
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Comments
A more meaningful way of interpreting that might be using your data:
There is roughly a 10 to 11% probability of the FED easing at every meeting between now and December...
Empirically its almost impossible to have a "subjective probability" for 4 FOMC meetings that doesn't approach 30%...
unless one is metaphysically sure that nothing will ever happen..
Posted by: sjonas at July 27, 2007 11:48 PM
Very true! But isn't the point that for the last several months, a lot of observers have been almost metaphysically sure that nothing would happen when looking ahead 2 or 3 meetings? As of just a few days ago, according to the Cleveland Fed charts, the the probabilities through October were only about 10%. So this does represent a little movement which is pretty much in accord with my own assessment.
Of course, I should also point out that the open interest in the binary options is limited and the trading is thin. (I did mention that the 500 December contracts today represent the entire open interest so far.) So I am cautious about drawing too much inference from this, but it is one part of the picture. The 30 day futures give the bulk of the picture and they went about as one would expect today.
I agree that the data suggests probabilities of approximately 10% at each of the four meetings. However, I suspect that some observers would put a lower probability on the first two and higher on the next two. I'll be very interested to see how the Sept, Oct, and Dec contracts respond (or not) after the next meeting.
Of course, there is also the possibility of a move between FOMC meetings as in 2001, though I don't think this possibility matters too much for the option pricing at this time.
It is a very interesting thing to watch, and I greatly appreciate your comments.
Posted by: William Polley at July 28, 2007 02:54 AM