Recovering market expectations of FOMC rate changes with options on federal funds futures

John Carlson (), Ben Craig and Will Melick ()

No 507, Working Papers (Old Series) from Federal Reserve Bank of Cleveland

Abstract: This paper demonstrates how options on federal funds futures, which began trading in March 2003, can be used to recover the implied probability density function (PDF) for future Federal Open Market Committee (FOMC) interest rate outcomes. The discrete nature of the choices made by the FOMC allows for a very straightforward recovery of the implied PDF using ordinary least squares (OLS) estimation. This simple recovery method stands in contrast to the relatively complicated PDF recovery techniques developed for options written on assets such as equities, foreign exchange, or commodity futures where the underlying prices are most appropriately modeled as being drawn from continuous distributions. The OLS estimation is used to recover PDFs for single FOMC meetings as well as PDFs for joint estimation of multiple FOMC meetings, and allows for the imposition of restrictions on the recovered probabilities, both within and across FOMC meetings. Finally, recovered probabilities are used to assess the impact of data releases and Fed communication on the perceived likelihood of actual policy outcomes.

Keywords: Federal Open Market Committee; Monetary policy; Interest rate futures (search for similar items in EconPapers)
Date: 2005
New Economics Papers: this item is included in nep-fmk, nep-ifn and nep-mon
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Citations: View citations in EconPapers (17)

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Journal Article: Recovering market expectations of FOMC rate changes with options on federal funds futures (2005)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedcwp:0507

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DOI: 10.26509/frbc-wp-200507

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