1. Money and Capital Markets 9 9 C h a p t e r Eighth Edition Financial Institutions and Instruments in a Global Marketplace Peter S. Rose McGraw Hill / IrwinSlides by Yee-Tien (Ted) Fu Interest Rate Forecasting & Hedging: Swaps, Financial Futures, & Options

2. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 2 Learning Objectives To see the effect of business cycle expansions and contractions upon interest rate movements. To consider the significance of seasonal movements in interest rates. To explore some interest-rate forecasting methods that are most widely used today. To examine several popular hedging tools, including interest rate swaps, financial futures, and option contracts.

3. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 3 The Influence of the Business Cycle in Shaping Interest Rates and Asset Prices Interest rates tend to fall (and debt security prices rise) during a business recession, while interest rates typically rise (and debt security prices fall) during an economic expansion. These phases of the business cycle may last months or years.

4. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 4 The Influence of the Business Cycle in Shaping Interest Rates and Asset Prices Source: Federal Reserve Bank of St. Louis, National Economic Trends, May 2002 Recessions as defined by the National Bureau of Economic Research

5. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 5 Relative Movements in Short- & Long-Term Rates & Prices over the Business Cycle In general, short-term interest rates tend to be more sensitive to business cycle changes than long-term interest rates on bonds and other capital market securities. On the other hand, long-term asset prices tend to be more volatile than the prices of short- term assets.

6. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 6 Relative Movements in Short- & Long-Term Rates & Prices over the Business Cycle % Time Long- term interest rates Short- term interest rates Expansion Contraction Peak of boom Recession trough Recession trough

7. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 7 Seasonality in Market Interest Rates There is evidence that interest rates also display seasonality, tending to be higher at some times of the year than at others. For example, short-term rates tend to rise through summer and autumn as businesses stock their shelves for the Fall season.

8. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 8 Forecasting Interest Rates: Advantages & Problems If interest rates can be forecasted accurately, borrowers can borrow when rates are supposed to be the lowest, while lenders can target the expansion of their lending programs to those periods when interest rates are expected to be the highest. Unfortunately, forecasting interest rates is far from easy, and may be virtually impossible.

9. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 9 Approaches to Modern Interest Rate Forecasting Money supply approaches consider the liquidity, expectations, and income effects of changes in a nations money supply. The Fisher effect asserts that the nominal (published) interest rate charged by a lender of funds must equal the lenders expected real rate of return on the loan plus the expected rate of inflation over the life of the loan.

10. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 10 Approaches to Modern Interest Rate Forecasting Econometric models employ variables like current and lagged values of money, income or total spending, and past rates of inflation, to predict interest rates through the application of statistical regression techniques. Market expectations can influence the financial markets. Indeed, the slope of the yield curve implies a forecast of interest rate changes expected by the public (implied rate forecasting).

11. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 11 Approaches to Modern Interest Rate Forecasting Yet another approach for the interest rate forecaster is to use several different methods to derive a consensus forecast.

12. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 12 Interest Rate and Asset Price Hedging Strategies Hedging refers to the act of coordinating the buying and selling of a commodity or financial claim to protect against the risk of future price fluctuations. Hedging tends to lower interest rate and price risk. However, it also tends to reduce the profit potential that could result from future interest rate and asset price changes.

13. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 13 Interest Rate and Asset Price Hedging Strategies The most popular hedging tools include swaps, futures, and options.

14. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 14 Interest Rate Swaps In this case, both firms can save on interest costs if each borrows in the market in which it has the comparative interest cost advantage.Can borrow in Supposethe long-termthe short-term bond market atloan market at Low-credit-rated borrower11%Prime rate + 0.50% High-credit-rated borrower10%Prime rate Quality spread1%0.50%

15. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 15 Interest Rate Swaps The Swap Agreement Low-credit-rated borrower gets a short-term loan from its bank at a floating interest rate (prime rate +.50%), but pays out the fixed interest cost on the long-term bonds issued by its swap partner. High-credit-rated borrower issues long-term bonds carrying a fixed interest rate (10%), but pays out a portion of the floating short-term interest rate owed by its swap partner. Pays 10% Pays prime rate –.25% Saves 0.25% on long-term rate. Saves 0.25% on short-term rate.

16. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 16 Interest Rate Swaps Today, borrowers often negotiate swap agreements with lenders at the same time as when they reach an agreement on a loan.

17. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 17 Interest Rate Swaps The Synthetic Fixed-Rate Loan Pays fixed interest rate Lender or other swap partner Pays floating interest rate Swap agreement: Borrower Lender Pays floating loan rate Loan agreement:

18. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 18 Financial Futures Contracts Under a typical financial futures contract, the seller agrees to deliver a specific security at a fixed price at a specific time in the future. At the delivery date, the seller can deliver the security, if he or she holds it; buy the security in the spot (cash) market and deliver it; or purchase a futures contract for the same security with the same delivery date (offsetting or zeroing out).

19. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 19 Financial Futures Contracts Today, most of the trading in financial futures centers upon contracts calling for the delivery of domestic and foreign government notes and bonds Eurodollar and other Eurocurrency deposits Federal funds futures contracts common stock indices (e.g. S&P 500) foreign currencies (e.g. ¥, )

20. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 20 Financial Futures Contracts Basically, three types of hedges are used in the financial futures market today. A long hedge involves the purchase of futures contracts today by an investor who must buy the actual securities at a later date. A short hedge involves the sale of futures contracts today by an investor who must sell the actual securities at some later point. A cross hedge involves futures contracts where the underlying asset is different from the actual asset that must be traded at a later date.

21. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 21 Financial Futures Contracts Profits from buying futures contracts (the long hedge) Profit Loss Futures contract (or asset) price FpFp – Fp– Fp Area of gain F p - original purchase price 0 Profits from selling futures contracts (the short hedge) Profit Loss Futures contract (or asset) price FpFp FpFp Area of gain F p - original purchase price 0

22. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 22 Option Contracts on Financial Futures An option contract is an agreement between a buyer and seller (the option writer) to grant the holder of the contract the right to buy or sell a futures contract or some other specified asset at a specified price (the strike price) before the contract expires. Call options give the contract holder the right (but not the obligation) to buy, while put options give the right to sell.

23. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 23 Option Contracts on Financial Futures The two most common uses of options involve protecting an investment against falling interest rates by using call options profit = market price – strike price – option premium protecting an investment against rising interest rates by using put options profit = strike price – market price – option premium

24. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 24 Option Contracts on Financial Futures Profit Loss Value of futures contract (or asset) Area of gain Payoffs to the Option Buyer from Put Options P r - option premium, S - strike price – Pr– Pr S 0 Profit Loss PrPr Area of gain Payoffs to the Option Writer from Put Options P r - option premium, S - strike price 0 Value of futures contract (or asset) S

25. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 25 Option Contracts on Financial Futures Profit Loss Value of futures contract (or asset) Area of gain Payoffs to the Option Buyer from Call Options P r - option premium, S - strike price – Pr– Pr S 0 Profit Loss PrPr Area of gain Payoffs to the Option Writer from Call Options P r - option premium, S - strike price 0 Value of futures contract (or asset) S

26. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 26 Money and Capital Markets in Cyberspace More information about interest rate forecasting and hedging can be found at: http://www.economy.com/dismal/ http://www.finpipe.com/derivatives.htm http://www.toron.com/ http://www.liffe.com/ http://www.cboe.com/ http://www.sfe.com.au/ http://options.about.com/ http://homepage.swissonline.net/FinCalc/

27. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 27 Chapter Review The Influence of the Business Cycle in Shaping Interest Rates and Asset Prices Relative Movements in Short- and Long-Term Interest Rates and Security Prices over the Business Cycle Seasonality in Market Interest Rates

28. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 28 Chapter Review Forecasting Interest Rates Advantages and Problems Approaches to Modern Interest Rate Forecasting Money Supply Approaches Inflation and the Fisher Effect Econometric Models Market Expectations and Implied Rate Forecasting The Consensus Forecast

29. 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 9 - 29 Chapter Review Interest Rate & Asset Price Hedging Strategies Interest Rate Swaps Financial Futures Contracts Securities Used in Financial Futures Contracts Types of Hedging in the Financial Futures Market Payoff Diagrams for Long and Short Futures Contracts Option Contracts on Financial Futures Basic Types of Option Contracts Uses of Options on Futures Contracts Payoff Diagrams for Valuing Options