In: Finance
When speaking about futures contracts specially interest rate contracts, many economic factors come into account to the behavior of prices of such tools. Please explain the main factors that would influence interest rate contracts and why? ten explain how governments and their decisions affect these contracts. Make sure and include some current events and decisions that have influenced the credit markets.
Interest rate contracts are also effected by factors like
1. Term structure - Term of the contract ie short term contracts have positive effect whereas negative effect on long-term ones
2. Volatility in the global interest rates
3. Risk free rate of return on Government securities
4. Spread ie Yield difference between highly rated bond and a similar government bond. For eg, The spread between LIBOR and T-bill rates can be used for calculation of premium.on interest rate futures.
5. Exchange rates
Any Government decision that causes or predicts change in risk free interest rate will surely effect the interest rate futures. Explaining with an example- Mr X pays a floating interest rate (@ 10%+ TBills) on the home loan.The government is expected to increase the risk free interest rate (same on TBills) in next 2 months, to restrict credit, encourage savings and control liquidity. In this case Mr X will be in losses because he will then pay higher interest rate. To hedge this he decides to buy interest rate futures equal to present in rate paid by him. The premium on these will increase as the end of 2 months increase.
Current events and decisions that have influenced the credit markets- Increase in Fed interest rate has influenced ineterst rates worldwide. Increase in interest rate would attract investment in the country, due to which other countries are forced to level interest rates along the line to avoid heavy outflow of the investment from their markets.