Update on our CME - Polymarket model

Disclaimer All content and information on this website (the "Site") is for informational and educational purposes only, does not constitute financial, investment, legal, or tax advice, and is not an offer, solicitation, or recommendation to buy or sell any security, futures contract, or financial instrument. No Investment Advice The author of this Site is not a financial advisor. The information presented is not intended to be and does not constitute personalized investment advice. Any discussion of securities or markets is for illustrative purposes only. You are solely responsible for your own investment decisions. You should not make any financial, investment, legal, or tax decision based on any of the information provided on this Site without first consulting a qualified and licensed professional and conducting your own research and due diligence. Risk of Loss All trading and investing involve a substantial risk of loss. The assets and strategies discussed on this Site may not be suitable for all investors. You may lose all or more than your initial investment. Past performance is not indicative of future results. No Warranties The information on this Site is provided on an "as is" basis. We make no warranties or representations, express or implied, as to the accuracy, completeness, or timeliness of the information. We are not liable for any errors, omissions, or any losses, injuries, or damages arising from your use of this information. Any forward-looking statements or market predictions are speculative by nature and are not guarantees. Disclosure The author may hold, buy, or sell positions in any assets, securities, or financial instruments discussed on this Site at any time and without notice. Personal Opinions All views and opinions expressed herein are the author's own and do not represent the opinions of any entity whatsoever with which the author has been, is now, or will be affiliated. Trying to find an arbitrage in the markets that are exposed to the next Fed decision - EFFR exposure remains an issue

ZQZ5 (Z = December, 5 = 2025)

CME contracts were price is 100-R where R = average EFFR in December

SR1Z5

CME contracts were price is 100-R where R = average SOFR in December

SR3U5 (U =  September)

CME contracts where price is 100-R where R = business-day compounded SOFR per annum during contract Reference Quarter (Ending December 2025)

Polymarket / Kelshi

Binary bet on fed decision

Initial strategy 

Strategy was to arbitrage the ZQZ5 contract with the binary bet, but that still leaves us exposed to EFFR movements 

In order to hedge against EFFR movements (which are cause by cash shortage in repo markets), we would initiate a long SR3 / short SR1 position as well. Both SOFR contracts are exposed to cash shortages as well, with SR1 being more sensitive since the SR3 contract has a 3 month buffer. 

In theory, the only thing that could blow our Binary / ZQZ5 arbitrage out of the water should be a sudden spike of the EFFR. If however the EFFR has spiked it is certain that SOFR will also have spiked, causing the our long SR3 and SR1 trade to make back the losses 

Summary of the trade: 

- Binary = - Policy risk 

+ ZQZ5 = + Policy risk + Repo market risk (from EFFR spike)

+SR3/-SR1 = Repo market risk (from SOFR spike)

P/L should theoretically depend on inefficiencies in risk pricing between the different markets

It should be noted that EFFR is less volatile than SOFR, meaning we could just buy the EFFR risk and not try to hedge it if we have a relatively good view on it

What is the EFFR and SOFR

The Effective Federal Funds Rate (EFFR) is the overnight interest rate at which banks lend reserves to each other, and it reflects monetary policy set by the Federal Reserve. 

The Secured Overnight Financing Rate (SOFR) measures the cost of overnight borrowing in the repo market using Treasury securities as collateral.

They generally track each other because both represent short-term funding conditions in U.S. dollar markets and are influenced by Fed policy and liquidity in the financial system. SOFR is more volatile because it is tied to repo transactions that can fluctuate with Treasury supply, market stress, or collateral demand, while EFFR is anchored more directly by the Fed’s rate tools. When EFFR rises, it usually signals tighter funding conditions or a shift up in policy rates, which tends to push SOFR higher as well since both markets respond to the same underlying liquidity and policy dynamics.

Precedent on EFFR and SOFR levels

Analyzing past EFFR and SOFR  levels relative to Target Rates and IORB

SOFR has recently traded very close to the EFFR, and has spike beyond the mid point of the boundaries given by the Fed. 

It is also evident that the SOFR tends to be more sensitive to movements (cause by cash shortage). In single terms: SOFR will trade lower than EFFR when market has plenty of liquidity, and the opposite when the market is “scared” of any shortage

Below is the relationship between EFFR percentile and SOFR percentile

The slope is 4.6, meaning if the EFFR goes from the 50th to the 51st percentile, SOFR should move by 4.6 percentiles 

Modeling the contracts - Current issues 

The ideas mentioned above however, does not create a pure arbitrage. With the assumptions we have made about relationships of EFFR and SOFR, while we are hedged if a cash shortage occurs, we start losing a disproportionate amount of money in case of an EFFR easing, thus we have not managed to turn our bet into a pure arbitrage, only made it way more sensitive to the repo market.

Same for ZQ/SR1 hedge. This only works under the assumption that the EFFR can only spike, not a risk we should be taking.

Thus the current issue remains, to try and find a way to hedge out our EFFR risk from the CME / Binary arbitrage.