Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries
Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries
Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries
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Borrowers, on the other hand, usually prefer to borrow at fixed ratesfor longer periods of time. For example, if the bank offers a relativelylow mortgage rate today, you would probably want to arrange a fixedrate mortgage for say the next 10 years so that you would be certa<strong>in</strong>that you get a good offer for a long period of time. In the absence ofany <strong>in</strong>centive to do otherwise, this is how people would behave, i.e.<strong>in</strong>vestors would deposit their money for short time periods, andborrowers would choose to borrow for longer periods. Banks wouldthen f<strong>in</strong>d themselves f<strong>in</strong>anc<strong>in</strong>g substantial amounts of longer-term fixedrate loans <strong>with</strong> short-term deposits. This would <strong>in</strong>volve a high degreeof <strong>in</strong>terest rate risk. In practice, <strong>in</strong> order to match depositors <strong>with</strong>borrowers and avoid the risk, banks raise long-term <strong>in</strong>terest rates relativeto expected future short-term <strong>in</strong>terest rates. This reduces the demandfor long-term fixed rate borrow<strong>in</strong>g and encourages <strong>in</strong>vestors to deposittheir money for long terms.This theory leads to a situation that long rates are higher than theexpected future short-term rates. It is consistent <strong>with</strong> the empiricalresult that yield curves tend to be upward slop<strong>in</strong>g more often than theyare downward slop<strong>in</strong>g.These three theories or the comb<strong>in</strong>ation thereof provide the fundamentalframework expla<strong>in</strong><strong>in</strong>g the term structure of <strong>in</strong>terest rates.Pric<strong>in</strong>g of a Forward Contract and the Yield Curve