Tài chính doanh nghiệp - Chapter 9: Interest rate forecasting & hedging: swaps, financial futures, & options

Chapter 9Interest Rate Forecasting & Hedging:Swaps, Financial Futures, & Options 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.IntroductionFor 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.Interest-Rate and Asset-Price ForecastingIf 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.Interest-Rate and Asset-Price ForecastingThere 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.Interest-Rate and Asset-Price ForecastingInterest 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.Interest-Rate and Asset-Price ForecastingIn 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.Interest-Rate and Asset-Price ForecastingInterest-Rate and Asset-Price ForecastingThere 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.The Economy, Interest Rates, and the Daunting Challenge of ForecastingWhile 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.Implied Rate and Price ForecastingSome 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.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 used today include interest-rate swaps, financial futures, and option contracts.Interest Rate SwapsInterest Rate SwapsThe result is usually lower interest expense for both firms and a better balance between cash inflows and outflows for both firms.Interest Rate SwapsSwaps 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.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:Interest Rate SwapsSwaps 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.Financial Futures ContractsIn 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.Financial Futures ContractsHedging 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.Financial Futures ContractsAn 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 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 loans and Treasury billscommon stock indices (e.g. S&P 500)foreign currencies (e.g. ¥, €)interest-rate swapsFinancial Futures ContractsLeading Futures and Options Exchanges Around the WorldFinancial Futures ContractsFinancial 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 ContractsAn Example of a Long Futures HedgeSource: Based on an example developed by the Chicago Board of TradeFinancial Futures ContractsAn Example of a Short Futures HedgeSource: Based on an example developed by the Chicago Board of TradeFinancial 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 FuturesExamples of Price Quotations on Option ContractsOption Contracts on Financial FuturesThe 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 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)SRisks, Costs, and Rules forTrading In DerivativesFutures and options trading has its risks and costs.Risks: basis risk, margin risk, liquidity riskCosts: brokerage fees, margin accountsThe decision to trade financial futures and option contracts is a cost versus benefit issue.Risks, Costs, and Rules forTrading In DerivativesThe 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.Markets on the NetChicago Board of Trade at www.cbot.comChicago Board Options Exchange at www.cboe.comChicago Mercantile Exchange at www.cme.comCommodity Futures Trading Commission at www.CFTC.comMarkets on the NetLondon International Financial Futures and Options Exchange at www.liffe.com The American Stock Exchange at www.amex.comThe Brussels Exchange at www.tripadvisor.comThe Financial Pipeline: Derivatives Concepts at www.finpipe.com/derivglossary.htmMarkets on the NetThe International Securities Exchange at www.iseoptions.comThe New York Board of Trade at www.nyce.com The Pacific Exchange at www.pacificex.comChapter ReviewIntroductionInterest-Rate and Asset-Price ForecastingThe Business Cycle and SeasonalityThe Economy, Interest Rates, and the Daunting Challenge of ForecastingImplied Rate and Price ForecastingInterest-Rate and Asset-Price Hedging StrategiesChapter ReviewInterest Rate SwapsWhat are Swaps?How Swaps WorkThe Risks of SwappingChapter ReviewFinancial Futures ContractsThe Nature of Futures TradingWhy Hedging Can Be EffectiveThe Purpose of Trading in Financial Futures Assets Covered by Financial Futures ContractsThe Exchanges Where Futures Trading OccursTypes of HedgesLong (Buying), Short (Selling) and Cross HedgesPayoff Diagrams for Long and Short Futures ContractsChapter ReviewOption Contracts on Financial FuturesBasic Types of Option ContractsUses of Options Payoff Diagrams for Valuing OptionsRisks, Costs, and Rules for Trading in DerivativesRisks and Costs Associated with Futures and OptionsAccounting Rules for Transactions Involving Derivatives