briefly discuss the interest rates determinants and how interest rates affects derivatives with empirical evidence? how are derivatives used for risk management purposes?

interest rates determinants

Supply and Demand

Interest rate levels are a factor of the supply and demand of credit: an increase in the demand for money or credit will raise interest rates, while a decrease in the demand for credit will decrease them. Conversely, an increase in the supply of credit will reduce interest rates while a decrease in the supply of credit will increase them.

An increase in the amount of money made available to borrowers increases the supply of credit. For example, when you open a bank account, you are lending money to the bank. Depending on the kind of account you open (a certificate of deposit will render a higher interest rate than a checking account, with which you can access the funds at any time), the bank can use that money for its business and investment activities. In other words, the bank can lend out that money to other customers. The more banks can lend, the more credit is available to the economy. And as the supply of credit increases, the price of borrowing (interest) decreases.

Credit available to the economy decreases as lenders decide to defer the repayment of their loans. For instance, when you choose to postpone paying this month's credit card bill until next month or even later, you are not only

Inflation

Inflation will also affect interest rate levels. The higher the inflation rate, the more interest rates are likely to rise. This occurs because lenders will demand higher interest rates as compensation for the decrease in purchasing power of the money they are paid in the future.

Government

The government has a say in how interest rates are affected. The U.S. Federal Reserve (the Fed) often makes announcements about how monetary policy will affect interest rates.

how interest rates affects derivatives with empirical evidence?

Understanding Interest Rate Derivatives

Interest rate derivatives are most often used to hedge against interest rate risk, or else to speculate on the direction of future interest rate moves. Interest rate risk exists in an interest-bearing asset, such as a loan or a bond, due to the possibility of a change in the asset's value resulting from the variability of interest rates. Interest rate risk management has become very important, and assorted instruments have been developed to deal with interest rate risk.

Interest rate derivatives can range from simple to highly complex; they can be used to reduce or increase interest rate exposure. Among the most common types of interest rate derivatives are interest rate swaps, caps, collars, and floors.

Also popular are interest rate futures. Here the futures contract exists between a buyer and seller agreeing to the future delivery of any interest-bearing asset, such as a bond. The interest rate future allows the buyer and seller to lock in the price of the interest-bearing asset for a future date. Forwards on interest rate operate similarly to futures, but are not exchange-traded and may be customized between counterparties.

Interest Rate Swaps

A plain vanilla interest rate swap is the most basic and common type of interest rate derivative. There are two parties to a swap: party one receives a stream of interest payments based on a floating interest rate and pays a stream of interest payments based on a fixed rate. Party two receives a stream of fixed interest rate payments and pays a stream of floating rate payments. Both payment streams are based on the same notional principal, and the interest payments are netted. Through this exchange of cash flows, the two parties aim to reduce uncertainty and the threat of loss from changes in market interest rates.

A swap can also be used to increase an individual or institution's risk profile, if they choose to receive the fixed rate and pay floating. This strategy is most common with companies that have a credit rating that allows them to issue bonds at a low fixed rate but prefer to swap to a floating rate to take advantage of market movements.

Caps and Floors

A company with a floating rate loan that does not want to swap to a fixed rate but does want some protection can buy an interest rate cap. The cap is set at the top rate that the borrower wishes to pay; if the market moves above that level, the owner of the cap receives periodic payments based on the difference between the cap and the market rate. The premium, which is the cost of the cap, is based on how high the protection level is above the then-current market; the interest rate futures curve; and the maturity of the cap; longer periods cost more, as there is a higher chance that it will be in the money.

A company receiving a stream of floating rate payments can buy a floor to protect against declining rates. Like a cap, the price depends on the protection level and maturity. Selling, rather than buying, the cap or floor increases rate risk.

How Can Derivatives Be Used for Risk Management?

• Derivatives are financial instruments that have values tied to other assets like stocks, bonds, or futures.
• Hedging is a type of investment strategy intended to protect a position from losses.
• A put option is an example of a derivative that is often used to hedge or protect an investment.
• Buying or owning stock and buying a put option is a strategy called the protective put.
• Investors can protect gains of a stock that has increased in value by purchasing a put.

increasing the amount of interest you will have to pay but also decreasing the amount of credit available in the market. This, in turn, will increase the interest rates in the economy.