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BobMurphy
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Posts: 41
Joined: May 25th, 2006, 6:32 pm

Hi, I've been doing research on recovering implied probabilities of FOMC actions, based on both fed funds futures and also options on them. In the Cleveland Fed pieces here, the authors explain that using just the futures price is fine if we only expect two likely Fed moves, whereas if the market entertains several possible moves, then you need the options in order to get a better idea of the implied PDF.Do people here agree with my intuitive explanation that this superiority (at least in theory) is because there are a range of strike prices, while at any time there is only one futures price?Second, if you agree that this is the reason, why exactly is it true? In other words, if people in the market actually have a whole PDF in their heads, with several possible outcomes (let's ignore the issue of people having different expectations for now), why does this spectrum get expressed in options prices, but is collapsed into a single number for the price of a future?I think I have an answer to this odd question, so please tell me if it sounds right. You could in fact have the analog of multiple strike prices for a futures contract, but it would be redundant. E.g. let's say right now the prevailing futures price of wheat delivered in one month is $100. (I'm switching to commodities for ease of exposition.) Now someone could in principle write up a contract to deliver wheat in one month at$110, i.e. a different "strike price." But since futures are being offered with a delivery price of $100, the potential buyer of this 2nd contract would need compensation, and would have to be paid the present value of$10 delivered next month to get him to accept this 2nd contract. So rather than go through this cumbersome process, it's easier to just write a contract with the prevailing $100 futures price and not exchange money upfront.Finally, if you still think I'm on the right track, this leads to the question: Why doesn't this redundancy occur with a call option? E.g. why bother having a call with a strike of$100 and a different one with a strike of \$110? Why is it that the price of these things doesn't render them equivalent, as I think happens with the hypothetical futures contracts with different delivery prices? Is it because calls needn't be exercised, while futures have no such optionality? Or is that not really what's driving this distinction?I realize these are some odd musings, but any thoughts would probably help organize my thoughts on this. Thanks.

BobMurphy
Topic Author
Posts: 41
Joined: May 25th, 2006, 6:32 pm

Whoops I forgot to give the link to the Fed working paper on this (in PDF format).

Posts: 23951
Joined: September 20th, 2002, 8:30 pm

The futures price encodes a market-aggregated estimate of the FOMC's expected action averaged across all possible FOMC and market reaction scenarios. As you said, the prices at the different strikes let the options prices encode different moves (e.g., hold, +0.25%, +0.50%, release meeting minutes that connote different future moves).Yes, the PDF is out there in the minds of the market participants. The futures market, however, only lets people buy/sell based primarily on the first moment of the PDF -- that is, a single average number. In other words, two very different combinations of FOMC scenarios (e.g., scenario 1 is a 75% chance of a 0.25% move and scenario 2 is a 35% chance of a 0.25% move and a 20% chance of a 0.50% move) might have the same futures price. In contrast, options let one take positions that represent the difference between these two hypotheticals. Even though the two scenarios have the same net expectation, market participants might care strongly about distinguishing the two scenarios. Someone who is very highly leveraged might survive a 0.25% move, but blow-up with a larger move.The bottom-line is that options, with a range of strike prices, give valuable information about the multiple potential outcomes.

BobMurphy
Topic Author
Posts: 41
Joined: May 25th, 2006, 6:32 pm