How interest rate futures work

In the countdown to the first Tuesday of each month when the Reserve Bank board meets to decide on interest rates, many analysts and journalists look to the market's pricing on interest rate changes.

References in the media, including on this website, to a "three-in-four chance" of a rate cut next month, or 75 per cent chance, are derived from the Swiss investment bank Credit Suisse's index of interest rate futures.

With the aim of shedding more light on the source of the information, here are some key points about the index:

• The chance of a rate cut or increase in Credit Suisse's interest rate futures index is derived from the average Reserve Bank cash rate pricing implied by the funding and credits costs of major banks and institutional investors.

• The biggest players in the index are Australian banks, which hedge their mortgage and other exposure by purchasing debt at a cost matching the rates they offer to clients. Global hedge funds and investment banks use the short-term money market too, pricing in their views not just of Australia's growth but of the wider Asian region and global economies.

• How much is the market worth? The market for Australian funding does not have a centralised exchange but is estimated to have a daily average turnover of about $30 billion by the Australian Financial Markets Association. Globally, it forms a small slice of the estimated $US13 trillion gross market value for all over-the-counter interest rate swaps.

• The volumes behind the trade vary but some transactions are worth as much as $2 billion alone. On a busy day, there may be as many as 10 such trades.

• Markets or economists historically are equally accurate although the market often leads economists' in showing shifting rate expectations.

• The market can continue to price rate cuts or rises that never come. This occurred when investors who had priced in RBA rate hikes by mid-2011 lost money after US debt was downgraded, markets plunged and sentiment changed. At that point a few large global funds began hedging that RBA interest rates would fall. Since the banks and funds that counted on rate rises had already lost money, they halted further bets of rate hikes. Their absence made the index show an unrealistically chance of a rate cut, as noted by the RBA.

• The RBA in their September 2011 meeting minutes said: “In Australia, market pricing prima facie pointed to expectations of large cuts in the cash rate by the end of the year, but a range of technical factors meant that market pricing might not be giving an accurate reading of expectations in the current circumstances.”