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BA 580-Interest Rates

BA 580-Interest Rates. Offsetting & Predicting Rate Movements. Interest Rate Risk Non-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

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BA 580-Interest Rates

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  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 @ $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 • Builder’s 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 (@ 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 = 95.7*****4.3% Mar = 95.4****4.6% Jun = 95.3*****4.7% Sep = 94.3****4.7% 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 What’s 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(t+j at t) = [(1 + Rt+j)t+j / (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 • Who’s Running the Fed • Who’s 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?

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