?..............if "they" ease 50 basis points, you'll get hurt on the short-Dec leg. It's a plausible scenario. We'll see.
50 bp cut: Dec = 100 - ((11 x 4.45)+(20 x 4.00))/31 = 95.84 Jan = 100 - ((28 x 4.00)+(3 x 3.75))/31 = 96.02 My entry prices: Dec 95.74 Jan 95.81 Under 50 bp cut scenario I lose 3 x 0.10 = -0.30 on the Dec and make 2 x 0.21 = +0.41 on the Jan for a net of +0.11 Do the math above for all plausible scenarios and you will see that, unless I am missing something, it is a good trade.
By the way, up for debate is our method of deriving the December projection. If I am in err, someone please correct me. Since my results are so close the Kevin's, I am not going to go as for as bothering myself to check the BOT website tonight. This would make a substantial difference of course if I were levered up in size. On the other hand, fed funds trading away from target rates tends to add a margin of error which may offset any faults in my calculation method. My method: Add: 4.41 4.49 4.31 4.5 4.51 4.5 +13 * newtarget Then divide this total by 19 total business days (christmas and new years excluded). Exact results are 95.685 and 94.856 for 25bp and 50bp respective cuts. Then I add 5 or 6 ticks to bump these up to 95.71 and 95.88, as fed funds tend to trade at rates a notch or three below targets. Oh lastly guys -- since you are always up for ideas ... here's a new blog post. http://scriabinop23.blogspot.com/2007/12/is-treasury-bull-done.html I'm getting bullish treasuries. I may be late to this party, but its a hedged trade with long equity calls.
I believe the calculation should be done on calendar days, including weekends and holidays. See page eight of the CBOT white paper at this URL: www.cbot.com/cbot/docs/67072.pdf I think that is too large a correction for the rest of December. For the week or so before a cut, yes, and we have seen that this past week, with the effective rate about 5.4 bp below the target. But the next cut won't come until the end of January, so I expect the effective rate to closely track the target, just as it did in November (Nov effective rate was 4.487). Interesting analysis, thanks for the link.
Fed funds futures settlement is based on calendar days. Weekends and holidays use the most recent day's rate. The basic 3x2 analysis is correct. However, the trade is essentially betting against the premium in the December contract. The market is scared of a Y2K situation where the Fed dumps in liquidity as we get close to end of year, making rates track very low. In addition, it's quite possible that they cut the discount rate by 25 bps more than the target rate today, basically putting a cap on upside tracking error. Short version: Kevin's trade is solid, but it's not an arb.
I dont understand what you mean here, care to explain how discount changes would have an effect on ff pricing
The discount window is where banks can borrow directly from the Fed; as of today they can borrow at 4.75%, with the target for *interbank* lending @ 4.25%. Basically, if you're a bank who needs overnight cash, and you can't get anyone to lend to you, for whatever reason, you can go to the Fed. But if you're willing to pay up 50 bps for funds, everyone figures there must be something seriously wrong with you. So the major deterrent right now is the fact that your counterparties worry about you being desperate. As a result, you're willing to pay up quite a bit in the interbank market. If the penalty were to be reduced to 25 bps, there would be many more players much more willing to use the discount window, removing the stigma. In other news, the previously discussed 3x2 spread didn't work today. In fact, no trade worked at all, really. Both Dec and Jan are unched. Now we get a big game of chicken in Dec.
Time to bring the thread back from the dead. I am thinking these come into play for some great interest rate hedge trades... Oct '14 futures are at 99.81 versus 99.87 settles we're seeing right now. 6 basis points ($250 of risk) for plenty of upside just in case of nervousness of earlier move. Also easy for Fed to reconfigure policy and pay higher IOR while keeping balance sheet same size just in case inflation starts to catch. And why do I mention that? Money printing is starting to transmit. Look at fraction of QE that is going into excess reserves, versus being transmitted to M2 growth greater than balance sheet expansion. You know how emotions can move these around. Early '16 trading closer to 50bp might give some great upside. Like the risk/reward ... kind of like shorting JGB with $3 of risk last week... (to zero rate constraint for 7 yr)