Can Derivatives Predict the Future of Markets?
Dec 13, 2021
By Frank Kaberna
Futures let you trade the future price for an asset in today’s market, which makes them great tools for speculating on and hedging the future path of prices. But futures aren’t just great trading vehicles...
Derivatives are a crowd-sourced predictive model. Thousands of people gathering on the bids and offers to voice their opinion on the future of an asset is essentially an efficient, real-time poll.
Fed Funds Futures
Take, for example, Fed Funds futures (ZQ) and the Fed Funds Rate. The former reflects where traders think the Federal Reserve will set rates at certain points in the future, while the latter is the actual rate as currently set by the Fed.
Source: Yahoo! Finance
How can a rate that is usually only altered a few times per year by the Federal Open Market Committee display so much movement day to day? The projection of where rates are headed in the future changes daily as a function of data releases, Fed statements, and general sentiment.
(Aside: Fed Funds futures are priced 100 - [Fed Funds Rate]; for example, a price of 98.60 reflects an expectation of 1.40% in the Fed Funds Rate.)
How Futures Predict the Future
The forward curve for any futures market presents the current prices for an asset at several dates in the future per corresponding contracts.
Source Yahoo! Finance
Prices declining as time is added demonstrates an expectation of rate hikes from the Fed; given the current rate of 0.125%, the projection is two or three 0.25% hikes in 2022, and another two or three in 2023.
Source: Yahoo! Finance
More straightforward pricing and greater accessibility make Small 2YR Yield futures a better route for acting on your opinion of these projections. A current price of 6.80* simply reflects an expectation of 0.68% for Treasury rates with two years of duration. Though there are some nuances between Fed Funds and Treasury rates, the two are highly correlated.
Think a couple of hikes in 2022 is too much too soon? You can sell S2Y. Think the Fed could hike even more? You can buy S2Y. Just keep in mind that futures tell you the future at the current moment, and that moment changes continuously.
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*As of 12/8/21