DEAR ALL

2. Chapter 9
Interest Rate Forecasting & Hedging:
Swaps, Financial Futures, & Options

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 Learning Objectives 
• To understand why financial analysts today usually choose
hedging (protecting) against losses from changing interest
rates and asset prices rather than attempting to forecast interest
rates or the prices of financial assets.
• To examine several popular hedging tools, including interest
rate swaps, financial futures, and option contracts.

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Introduction
• For actively traded assets, demand and supply forces are
continually shifting, such that investors interested in these
assets must constantly stay abreast of the latest developments.
• It is thus no wonder that accurate interest-rate and asset-price
forecasting is so difficult, if not impossible.

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Interest-Rate and Asset-Price
Forecasting
• 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.

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Interest-Rate and Asset-Price
Forecasting
• There are, however, a few predictable aspects to interest-rate
and asset-price movements.
• To understand these few regularities and how the financial
markets account for them can significantly reduce the
exposure of one’s investments to interest-rate and price
movements and minimize market risk.

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Interest-Rate and Asset-Price
Forecasting
• Interest rates tend to fall (and debt security prices rise) during
a business recession, and rise (and debt security prices fall)
during an economic expansion.
• These phases of the business cycle may last months or years.

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Interest-Rate and Asset-Price
Forecasting
• 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.

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Interest-Rate and Asset-Price
Forecasting

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Interest-Rate and Asset-Price
Forecasting
• There is evidence that interest rates also display seasonality,
tending to be higher at some times of the year than at others.
• For example, some short-term rates tend to rise through
summer and autumn as businesses stock their shelves for the
Fall season.

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The Economy, Interest Rates, and the
Daunting Challenge of Forecasting
• While we may not be able to consistently make accurate point
forecasts, we may be more successful at making directional
forecasts.
• Unfortunately, the economy can be very difficult to forecast
too.
• Furthermore, research increasingly suggests that interest rates
come close to following a random walk, although they appear
to exhibit mean reversion over the very long run.

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Implied Rate and Price Forecasting
• Some financial analysts and active market investors place
considerable weight on what is called implied forecasting.
• This forecasting technique relies upon measures of the public’s
expectations to help predict the future.
• In particular, expectations about future interest rates are
embedded in the market prices of financial assets.

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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.

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Interest Rate and Asset Price
Hedging Strategies
• The most popular hedging tools used today include interest-
rate swaps, financial futures, and option contracts.

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Interest Rate Swaps

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Interest Rate Swaps
• The result is usually lower interest expense for both firms and a better
balance between cash inflows and outflows for both firms.

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Interest Rate Swaps
• Swaps work because the interest-rate spreads related to default
risk (called quality spreads) are generally greater in the long-
term capital market than they are in the short-term money
market.

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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 Can borrow in
Suppose the long-term the short-term
bond market at loan market at
Low-credit-rated borrower 11% Prime rate + 0.50%
High-credit-rated borrower 10% Prime rate
Quality spread 1% 0.50%

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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.

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Interest Rate Swaps
• Today, borrowers often negotiate swap agreements with
lenders at the same time as when they reach an agreement on a
loan.

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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:

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Interest Rate Swaps
• Swaps help to cover interest-rate risk but do not necessarily
reduce credit (default) risk.
• However, because the notional amount of a swap is not at risk,
a swap is typically less risky than a bond.
• Note that swaps themselves are subject to interest-rate risk 
shifts in market interest rates can alter the value of existing
swap agreements.

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Financial Futures Contracts
• In a typical financial futures contract, the seller agrees to
deliver a specific security at a specific price at a specific time
in the future.
• Hedging in futures does not reduce risk. Instead, it is a low-
cost method of transferring the risk of unanticipated changes
in prices or interest rates from one investor or institution to
another.

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Financial Futures Contracts
• Hedging through futures essentially involves adopting equal
and opposite positions in the spot and futures markets for the
same assets.
• The basis for a futures contract is the spread between the spot
price of an asset and the forward price for that same asset at
the same point in time.
• Hedging through futures converts price or interest rate risk
into basis risk.

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Financial Futures Contracts
• An investor can sell financial futures contracts on an asset to
protect against the risk that the asset’s price may fall.
• 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).

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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 loans and Treasury bills
- common stock indices (e.g. S&P 500)
- foreign currencies (e.g. ¥, €)
- interest-rate swaps

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Financial Futures Contracts
Leading Futures and Options Exchanges Around the World

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Financial Futures Contracts

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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.

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Financial Futures Contracts
An Example of a Long Futures Hedge
Source: Based on an example developed by the Chicago Board of Trade

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Financial Futures Contracts
An Example of a Short Futures Hedge
Source: Based on an example developed by the Chicago Board of Trade

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Financial Futures Contracts
Profits from buying futures
contracts (the long hedge)
Profit
Loss
Futures
contract
(or asset)
price
Fp
–Fp
Area of
gain
Fp - original purchase price
0
Profits from selling futures
contracts (the short hedge)
Profit
Loss
Futures
contract
(or asset)
price
Fp
Fp
Area
of gain
Fp - original purchase price
0

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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.

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Option Contracts on Financial Futures
Examples of Price Quotations on Option Contracts

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Option Contracts on Financial Futures
• The two most common uses of options involve
 protecting an investment against falling interest rates
by using call options
Before-tax profit =
market price – strike price – option premium
 protecting an investment against rising
interest rates by using put options
Before-tax profit =
strike price – market price – option premium

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Option Contracts on Financial Futures
Profit
Loss
Value of
futures
contract
(or asset)
Area
of gain
Payoffs to the Option Buyer
from Put Options
Pr - option premium, S - strike price
–Pr
S
0
Profit
Loss
Pr Area of
gain
Payoffs to the Option Writer
from Put Options
Pr - option premium, S - strike price
0
Value of
futures
contract
(or asset)
S

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Option Contracts on Financial Futures
Profit
Loss
Value of
futures
contract
(or asset)
Area
of gain
Payoffs to the Option Buyer
from Call Options
Pr - option premium, S - strike price
–Pr
S
0
Profit
Loss
Pr
Area of
gain
Payoffs to the Option Writer
from Call Options
Pr - option premium, S - strike price
0
Value of
futures
contract
(or asset)
S

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Risks, Costs, and Rules for
Trading In Derivatives
• Futures and options trading has its risks and costs.
- Risks: basis risk, margin risk, liquidity risk
- Costs: brokerage fees, margin accounts
• The decision to trade financial futures and option contracts is a
cost versus benefit issue.

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Risks, Costs, and Rules for
Trading In Derivatives
• The rapid expansion of derivatives trading has also led to new
accounting rules to promote fuller disclosure of risk exposures
and to permit management and outsiders to judge the
effectiveness of these hedging techniques.

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Markets on the Net
• Chicago Board of Trade at www.cbot.com
• Chicago Board Options Exchange at www.cboe.com
• Chicago Mercantile Exchange at www.cme.com
• Commodity Futures Trading Commission at www.CFTC.com

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Markets on the Net
• London International Financial Futures and Options Exchange
at www.liffe.com
• The American Stock Exchange at www.amex.com
• The Brussels Exchange at www.tripadvisor.com
• The Financial Pipeline: Derivatives Concepts at
www.finpipe.com/derivglossary.htm

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Markets on the Net
• The International Securities Exchange at www.iseoptions.com
• The New York Board of Trade at www.nyce.com
• The Pacific Exchange at www.pacificex.com

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Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Chapter Review
• Introduction
• Interest-Rate and Asset-Price Forecasting
- The Business Cycle and Seasonality
- The Economy, Interest Rates, and the Daunting Challenge of
Forecasting
- Implied Rate and Price Forecasting
• Interest-Rate and Asset-Price Hedging Strategies

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Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Chapter Review
• Interest Rate Swaps
- What are Swaps?
- How Swaps Work
- The Risks of Swapping

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Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.
Chapter Review
• Financial Futures Contracts
- The Nature of Futures Trading
- Why Hedging Can Be Effective
- The Purpose of Trading in Financial Futures
- Assets Covered by Financial Futures Contracts
- The Exchanges Where Futures Trading Occurs
- Types of Hedges
• Long (Buying), Short (Selling) and Cross Hedges
- Payoff Diagrams for Long and Short Futures Contracts

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Chapter Review
• Option Contracts on Financial Futures
- Basic Types of Option Contracts
- Uses of Options
- Payoff Diagrams for Valuing Options
• Risks, Costs, and Rules for Trading in Derivatives
- Risks and Costs Associated with Futures and Options
- Accounting Rules for Transactions Involving Derivatives