I thought it would be interesting to compile a list of things that happen when markets rates rise. I know a few but Ill list one for now. 1. Prepayments decrease which in turn increases the return to IO bondholders
- Increases extension risk in Mortgage backed securities 3. Creates capital account surplus as there will be an inflow of foreign dollars 4. Which in turn makes a domestic currency appreciate
- Decreases the return to PO bondholder due to less prepayments (longer to get capital)
- Usually WON’T effect Auto-backed loans, as they are too short in term and for too little money to bother with the refinancing
- you’ll want to long a put option on fixed instruments if you are holding a LIBOR-based liability… 8. or a call option on a bond… 9. if you want an alternative to buying a cap.
- There will be a decrease in the Money Supply to an Economy as it becomes more expensive to borrow because of the increase in market rates. 11. The domestic currency will appreciate in the Short Run due to the decrease in money supply. In the Long Run the currency should depreciate realitive to foreign currencies due to interest rate parity. 12. Expected Inflation should decrease. 13. Equity investments should increase in value. 14. Future contracts that are positively correlated to interest rates should increase in value. Forward contracts with the same parameters should decrease in value. 15. Future contracts that are negatively correlated to interest rates should decrease in value and Foward contracts that are negatively correlated should increase in value because of not being marked to market. 16. The value of a FRA to the long will increase. 17. The Fixed payer in a Swap normally will be better off than a Floating or Equity Index payer. 18. Over the long run assets should be higher for a foreign subsidiary in which the Current Rate method is used versus a subsidiary that uses the Temporal Method due to Long Run Foreign Currency Appreciation. Short run would be opposite. As a result mixed financial ratios will be conflicting between the two methods.
joseph213 Wrote: ------------------------------------------------------- > 7. you’ll want to long a put option on fixed > instruments if you are holding a LIBOR-based > liability… > > 8. or a call option on a bond… > > 9. if you want an alternative to buying a cap. Why a call option on a bond? Rising interest rates would decrease bond values. I think a put would be more appropriate. Or a call on on IR
Hank Scorpio Wrote: ------------------------------------------------------- > joseph213 Wrote: > -------------------------------------------------- > ----- > > 7. you’ll want to long a put option on fixed > > instruments if you are holding a LIBOR-based > > liability… > > > > 8. or a call option on a bond… > > > > 9. if you want an alternative to buying a cap. > > > Why a call option on a bond? Rising interest > rates would decrease bond values. I think a put > would be more appropriate. Or a call on on IR My mistake. You’re right. It would be a call option on interest rate.
I think it should be “sell” a call option on a bond…right? And benefit from collecting the premium. In general though, when I/R goes up, call prices go up and put prices go down (I’m assuming this is for equity options). I’ve had the reasoning behind this explained to me 3 different ways. Is the simpliest way to remember based on Investor83’s comment - that when I/R goes up, equity investments go up? This makes no sense to me, unless it’s only for short phenomenon. How can equities sustain high values with high I/R and costs of capital?? And sorry for breaking the chain, I suppose mine would be… 19. Call option [equity] prices go up and put option [equity] prices go down
Lumberjack it is short term on some occasions. Steady, high interest rates usually exist because of persistence of inflation. Equity prices increase with inflation. As interest rates increase, fixed income investments drop in value. Normally this would be a good time to buy fixed income investments for the logical investor. However, using the Behavioral Finance and Economic idea of “Animal Spirits”, typical investors are not logical. They buy high and sell low. In the Short Run they will sell out of their depressed fixed income investments and buy the overvalued equity investments in hope of continuing positive returns. Equity prices were driven up by inflation and now that interest rates have been increased to slow down economic overheating, we see cost of capital increase as you correctly stated. In the Long Run increased cost of capital could effect profitability on the micro(company) scale and decrease money supply on the macro(market) scale. With increased cost of capital, intrinsic value of investments decrease and the market prices adjust(at whatever pace based on your efficient market beliefs). As a result of the decreased money supply, there is less capital available for investors to access and invest in companies. Also, there will be decreasing growth rates due to less capital available for companies use for project investments and intrinsic value will drop. Ultimately, investors are irrational and buy high, further driving up equity prices in the short run. The question is how long the short run last. This is very tough for economists to predict.
Lumberjack, I agree that you cannot say that equities will definitely go up or down due to a rise in market rates. The rise in equities would be caused by an overheated economy The rise in mkt rates is a reaction to a rise in inflation You could say that an over heated economy causes inflation and as a reaction mkt rates are then raised; but to say that an increase in mkt int rates causes the equity prices to rise would be incorrect. These two may be somewhat correlated but it is spurious, they are both caused by a third underlying factor - inflation. and besides, Investor83 said that Equities SHOULD increase not that they will.
Thanks to both! When you add inflation to the synthesis (which hadn’t previously been explained to me), it makes more sense.