Many times on the news you will here statements like “traders are pricing in a 42% chance of a rate rise at the next meeting of the Federal Reserve”. I got to wondering how they could be so precise and went searching for the formula. After looking high and low, I eventually found it in Stephen Aitkin’s book on “Trading STIR Futures“. The formula works as follows:

C = Chance of a Rate Change

IR = 3 month Libor Interbank Rate. (you can get Libor data from esignal or from bloomberg)

S = current price of the STIR future

E = expected rate movement (i.e. average of a panel of economist expectations around)

C = (100 - S - IR) / E

If C is negative then it is a chance of a rate cut.

For example, if on 1 February 2006, the M6 Short Sterling contract was 95.38, the 3 month interbank Libor Rate is 4.52% and the expected rate rise is 25 basis points, then:

C = (100 - 95.38 - 4.52) / 0.25

C = 0.1 / 0.25

C = 0.40

C = 40% probability of a 25 basis point rate hike by the time the M6 contract expires.

Nice, but can you trade it?

Trading interest rate expectations is best done by finding examples of where expectations around rates are high (larger than 60%) and then trading examples where expectations are not met as the price will move quite violently.

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