BA 580Interest Rates

1
BA 580-Interest Rates

• Offsetting Predicting Rate Movements

2
Interest Rate RiskNon-Financial Business

• Subdivision Builder
• Constructing 10 mil. (est) development
• 1 year completion time
• Value of property if interest rates go up home
  buyers net debtors
• PV Project 30m if rates up to 7
• PV Project 50m if rates stay at 6
• PV Project 70m if rates down to 5
• How can builder protect against this interest
  rate risk?

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

• Futures Contract
• Contract with standardized terms regarding item
  under contract (e.g. T-Bond)
• Traded on organized exchanges (marketability)
• Payments guaranteed (Clearinghouses)
• Forward contract a non-exchanged traded contract
  between two parties
• Useful for non-standardized items
• Credit-risk for counterparties

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

• CBOE markets interest rate options
• Simpler than futures (trading explicitly in terms
  of interest rates)
• Right v. obligation (but pay for this)
• Interest rate options markets not nearly as
  heavily traded as Treasury futures

8
Predicting Rates with Market Data

• Nature of Market Forecasts of Rates
• Contracts (futures) on What Rates (or prices)
  will be in March, June, Sept,
• Contracts on variety of Rate-related items
• Fed Funds T-Bills LIBOR T-Notes
• Implied Rates (see later slide)
• Advantages of Market Forecasts
• Millions of people putting behind choices
• Some of these people very well informed
• Availability of (free to public) information

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

• Yield Curve rates based on time differences
• Looking from start, yield curve shows1 yr. rate,
  2 yr., 3 yr. rate
• Embedded or Implied Rates in Yield Curve
• Go out to 1 yr. and look ahead 1 yr.
• This segment implies a rate for 1 yr. loan in 1
  yr.
• Implied by current 1 yr. and 2 yr. rates
• Formula (1 2-yr Rate)2 / (1 1yr Rate) 1
• Currently (Treasuries) (1.0442)2/(1.0441) -1
  4.43
• General Formula (see forwardyields.xls)
• IFR(tj at t) (1 Rtj)tj / (1 Rt(1/j)
  1
• t starting time period
• j how many time periods ahead looking

12
Market Rate Forecasts

• Good News!
• St. Louis Fed (and others) calculate and publish
  IFR
• Also provide FF Rate Futures Data
• Also Show Inflation-Indexed Yield
• See St. Louis Fed Monetary Trends (page 11)

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

14
Awareness of Interest Rate Influencing Events

• What Moves the Bond Market
• (NY Fed Article www.ny.frb.org)
• Announcements (News)
• Employment PPI Fed Funds Target retail sales
• Political Economy
• Whos Running the Fed
• Whos Confirming Fed Nominees?

15
The Blinder Affair

• Alan Blinder
• Princeton Prof
• Subscribed to Post-Depression view
  (inflation-employment tradeoff)
• Appointed Vice Chair of Fed June 1994
• Greenspan no fan
• Republicans take Congress 2004
• Blinder resigns Jan 2006
• See Woodward book Maestro

16
Bernanke?

• Greenspan announces retirement Sept 2006
• Bernanke announced on Oct 24, 2006
• Problems in determining causes effects?