Tài chính doanh nghiệp - Interest rate forecasting & hedging: Swaps, financial futures, & options

Money and Capital Markets9C h a p t e rEighth EditionFinancial Institutions and Instruments in a Global MarketplacePeter S. RoseMcGraw Hill / IrwinSlides by Yee-Tien (Ted) FuInterest Rate Forecasting & Hedging:Swaps, Financial Futures, & Options 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.The Influence of the Business Cycle in Shaping Interest Rates and Asset PricesInterest 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.The Influence of the Business Cycle in Shaping Interest Rates and Asset PricesSource: Federal Reserve Bank of St. Louis, National Economic Trends, May 2002Recessions as defined by the National Bureau of Economic ResearchRelative Movements in Short- & Long-Term Rates & Prices over the Business CycleIn 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.Relative Movements in Short- & Long-Term Rates & Prices over the Business Cycle%TimeLong-terminterestratesShort-terminterestratesExpansionContractionPeak of boomRecessiontroughRecessiontroughSeasonality in Market Interest RatesThere 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.Forecasting Interest Rates:Advantages & ProblemsIf 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.Approaches toModern Interest Rate ForecastingMoney supply approaches consider the liquidity, expectations, and income effects of changes in a nation’s money supply.The Fisher effect asserts that the nominal (published) interest rate charged by a lender of funds must equal the lender’s expected real rate of return on the loan plus the expected rate of inflation over the life of the loan.Approaches toModern Interest Rate ForecastingEconometric 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).Approaches toModern Interest Rate ForecastingYet another approach for the interest rate forecaster is to use several different methods to derive a consensus forecast.Interest Rate and Asset PriceHedging StrategiesHedging 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.Interest Rate and Asset PriceHedging StrategiesThe most popular hedging tools include swaps, futures, and options.Interest Rate SwapsIn 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 Can borrow inSuppose the long-term the short-term bond market at loan market atLow-credit-rated borrower 11% Prime rate + 0.50%High-credit-rated borrower 10% Prime rateQuality spread 1% 0.50%Interest Rate SwapsThe Swap AgreementLow-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.Interest Rate SwapsToday, borrowers often negotiate swap agreements with lenders at the same time as when they reach an agreement on a loan.Interest Rate SwapsThe Synthetic Fixed-Rate LoanPays fixed interest rateLender orother swappartnerPays floating interest rateSwap agreement:BorrowerLenderPays floating loan rateLoan agreement:Financial Futures ContractsUnder 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 candeliver the security, if he or she holds it;buy the security in the spot (cash) market and deliver it; orpurchase a futures contract for the same security with the same delivery date (offsetting or zeroing out).Financial Futures ContractsToday, most of the trading in financial futures centers upon contracts calling for the delivery ofdomestic and foreign government notes and bondsEurodollar and other Eurocurrency depositsFederal funds futures contractscommon stock indices (e.g. S&P 500)foreign currencies (e.g. ¥, €)Financial Futures ContractsBasically, 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.Financial Futures ContractsProfits from buying futures contracts (the long hedge)ProfitLossFutures contract (or asset) priceFp– FpArea ofgainFp - original purchase price0Profits from selling futures contracts (the short hedge)ProfitLossFutures contract (or asset) priceFpFpAreaof gainFp - original purchase price0Option Contracts on Financial FuturesAn 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.Option Contracts on Financial FuturesThe 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 premiumOption Contracts on Financial FuturesProfitLossValue of futures contract (or asset)Areaof gainPayoffs to the Option Buyerfrom Put OptionsPr - option premium, S - strike price– PrS0ProfitLossPrArea ofgainPayoffs to the Option Writerfrom Put OptionsPr - option premium, S - strike price0Value of futures contract (or asset)SOption Contracts on Financial FuturesProfitLossValue of futures contract (or asset)Areaof gainPayoffs to the Option Buyerfrom Call OptionsPr - option premium, S - strike price– PrS0ProfitLossPrArea ofgainPayoffs to the Option Writerfrom Call OptionsPr - option premium, S - strike price0Value of futures contract (or asset)SMoney and Capital Markets in CyberspaceMore information about interest rate forecasting and hedging can be found at: ReviewThe Influence of the Business Cycle in Shaping Interest Rates and Asset PricesRelative Movements in Short- and Long-Term Interest Rates and Security Prices over the Business CycleSeasonality in Market Interest RatesChapter ReviewForecasting Interest RatesAdvantages and ProblemsApproaches to Modern Interest Rate ForecastingMoney Supply ApproachesInflation and the Fisher EffectEconometric ModelsMarket Expectations and Implied Rate ForecastingThe Consensus ForecastChapter ReviewInterest Rate & Asset Price Hedging StrategiesInterest Rate SwapsFinancial Futures ContractsSecurities Used in Financial Futures ContractsTypes of Hedging in the Financial Futures MarketPayoff Diagrams for Long and Short Futures ContractsOption Contracts on Financial FuturesBasic Types of Option ContractsUses of Options on Futures ContractsPayoff Diagrams for Valuing Options