Federal Funds: Pricing and Risks

Fed fund yields are quoted on an add-on basis on an actual/360-day basis. The fed funds rate is a key rate for the money market. Bid/offer spreads may vary among institutions, although the differences are usually slight.

The Wall Street Journal publishes the fed effective rate on overnight fed funds, which is the weighted average of all fed funds transactions done in the broker’s market.

The general credit quality of banks is rated by Thompson Bankwatch. These ratings are used by banks when determining credit risk for Fed funds sold.

Term fed funds rates are quoted over-the-counter or in the broker’s market.

Money market brokers also publish indicative quotes on the Telerate screen.

Risks

The three key risks are interest rate risk, credit risk, and liquidity risk.

Interest-Rate Risk

Since non-term fed funds have very short maturity, there is minimal interest rate risk. However, for term fed funds, the interest rate risk increases with the increase in term.

Credit Risk

Sellers of fed funds are exposed to credit risk. Therefore collateral may be required to compensate for their risks. Lending banks are required to assess the credit quality of borrowers and also set limits for each potential counterparty.

Liquidity Risk

The fed fund overnight market is highly liquid. There is is no secondary market for term fed funds rates, and their liquidity is directly related to their maturity.