Any one out there trade fed fund futures or options on them? It seems to me like they are often mispriced because of all the institutional hedging that result in mispricing of true probabilities. Any thoughts advice or warnings about trading these things?
If nothing else Fed Funds futures at expiration are priced on a tangible benchmark. The Funds rate is what it is, eh? Now the challenge of predicting what the Funds rate will be, looking forward. Most short term interest rate hedging is executed in ED. However the ED rate is based upon LIBOR rather than Treasuries. ED is really a glorified Bank CD contract with cash settlement rather than delivery of actual CD's. In the early 80's both the CME and CBOT had CD contracts that were "victimized' by delivery of VERY cheap to deliver CD's by Continental Bank of Illinois. (As a 21 year old clerk I picked up 30k making delivery in the contract.) So ED was a better way of creating a CD contract. Fed Funds is a better way of allowing risk transference in overnight rates without the basis risk of LIBOR vs. Treasuries. IMO there's a BETTER chance of ED being "mispriced" than FF. More valuation variables lead to better opportunities. If however you merely want to speculate on the ON rate, FF is the best vehicle. BTW: Look at the entire strip for spread ideas.
There is a guy at Graham capital with a fund based on his views of Fed poilcy who tkaes positions in the euiro options almost exclusively who has done abot 18%/yr. He pretty much sells straddles/ buys butterflys.
Be careful trading these, there are some odd side effects. 1) The FF rate is determined by the *average* rate for the month. So, if the fed meets on the 29th of the month and changes rates, the FF contract expiring that month will not move very much. 2) I've now had problems with both IB and Man Financial trading FF options. Both had programmed their systems with the mutliplier for the percent (i.e. the multiplier for the futures contract). However, options are quoted in basis points, not percent. A $625 option straddle was charged to my account at $62,500. Man's solution was to pretend options are quoted in percent and fix my fill price. IB is still quoting basis points. Nothing like confusion...