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BA 580Interest Rates

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Title: BA 580Interest Rates

1
BA 580-Interest Rates

2
Interest Rate RiskNon-Financial Business

3
Hedging with Forward Contracts

Forward Contract on Project
Buyer A willing to purchase project _at_ 50m in 1
yr.
Issues finding buyer evaluating buyer credit
risk
Forward Contract on Interest Related to Project
Buyer A pays builder 20m if rate 7
Buyer A pays builder 50m if rate 6
Builder pays Buyer A 20m if rate 5
Features of This Kind of Financial (rate) Hedge
Hedge regards i-rate, not Project per se
Builder locks in gain of 50m (gain-loss of
20m negatively correlated with PV project)
Net value of contract 0
Builder protecting asset value (builder gets 50m
in each case)
Buyer A outcomes (-20m, 0, 20m)
Builder (hedger) transferring risk to Buyer A
(speculator)

4
Hedging with Futures Contract

5
Hedging with T-Bond Futures Contract

Builders Problem
20m risk (loss) if rate up to 7
To hedge this risk fully, requires taking a
position where the builder receives 20m if rates
go up to 7
Aim is to lock in 50m PV (_at_ 6 rate)
Mechanics (CBOT Trades)
Sell Buy T-Bond Contracts (Delivery Date Mar
Dec 07)
Selling Future Contract gain if price of T-bond
falls (i-rate rises)
Cancel position in Mar 07 by buying T-bond
futures in equal amounts for same delivery date
(buying at lower price than contracted selling
price)
If price increases (i-rate falls), lose money on
futures contract but gain on PV of project
Features of Futures Contract
Again, hedge pertains to i-rates, not Project
Negative correlation of hedge project payoffs
the key to builder
Options on futures contracts make hedging
downside risk possible without giving up all of
upside gain (See your Finance classes)

6
Additional Points on Futures

Options on Futures
Builder could pay fee (premium) to buy options on
the amount of T-Bond futures contracts
Warnings
You must have title or claim to an asset to
hedge, otherwise, you are speculating
To hedge rate risk accurately, your estimates of
the PV of the project must be correct

7
Hedging with Interest Rate Options

8
Predicting Rates with Market Data

9
Example of Predicting Rates with Market Data

Current CBOT data on Fed Funds Futures
Jan 95.74.3
Mar 95.44.6
Jun 95.34.7
Sep 94.34.7
Note Predicted FF Rate 100 Price
Note Prediction about s.t. rate (FF) in 3, 6, 9
months not like yield curve which merely shows
current rates of different length loans

10
Another Example Using Bond Futures

Spot rate (yield to maturity) on 30-yr. T-Bond
4.64
On CBOT, 30 yr. T-Bond Dec 06 Future
Price 113.09
Implies Rate (ytm) 5.12
This uses Investopedia ytm calculator with 6
coupon, 29 years to maturity (See CBOT Contract
Specs for details)
This is an approximation there are issues
surrounding 6, frequency of payments, See
Merrick (NYU) for gory details
So, market prediction is for small rise in 30 yr.
T-bond rate by end of 06

11
Rate Predictions from Whats Implied

12
Market Rate Forecasts

13
Quick Overview of Rate Forecasts from Scratch

Statistical Forecasting Models
Based on using patterns in past data to build
model
Plug in known values to generate predictions
Univariate Models
Use past values of Rate being studied to forecast
future values
Time efficient
Based on idea that some inherent stability to
movements
Not great at getting at unusual periods
Structural Models
Use past values of interest influencing variables
(inflation income politics ) to build model
Plug-in current current or predicted values of
these to predict interest rates