Notes on Chapter 5Notes on Chapter 5- Influence of business cycle in shaping interest rates-- economic expansion lead to increase in both short-term and long-term interest rates, while recession generally resultin decline in all rates sooner or later. Both short-term and long-term rates tend to rise and fall together, though lags are often observed with short-term rate changes often preceding long-term rate changes. - Modern Interest Rate Forecasting—money supply approach Liquidity effect/ Default RiskLiquidity is the ease and speed with which an asset can be turned into cash relative to thealternative asset. Liquidity management is the ability to meet maturing obligation,appropriately matching asset and liabilities to cover payments as they become due. Activeliquidity management requires specific financial skills and systems for asset/liabilitymatching to control risk exposure—delinquency level. From investor side the more liquidan asset is relative to alternative asset, holding everything else unchanged, the moredesirable it is, and the greater will be the quantity of demand. Knowing how to measureliquidity on the balance sheet, planning the vault cash, integrating liquidity with riskmanagement, knowing how to manage liquidity in multiple currency, and assessing ourliquidity risks are essential cash management expertise.  Expectation effect Income effect—rising income tend to increase demand for money resulting in higher interest rate. Fisher effect—rising price level and inflation is connected to rising interest rate. Forward Calendar effect—forward calendar lists new security issues expected to come to the market within the next few weeks or months. These listing are representation of the future supply of securities coming to the market or future demand on credit. Econometric Models- Interest Rate Hedging Strategies—hedging is the attempt to protect oneself from adverse movement in prices, in particular from adverse changes in interest rates. Interest rate caps—limits how high interest rate can reach on a loan through a fee that borrower pays to the lender to secure the cap rate. Rate callers—limits both floor and ceiling of the interest rate attached to a loan and protects both borrower and lender. Interest rate insurance—a borrower pays a premium to an insurer to receive protection against rising interest rate. If rates exceed the maximum the insurer pays the additional interest expenses incurred by borrower. Interest rate option—allows a guaranteed rate within a fixed period of timefor the borrower. The borrower can exercise its option within the given time. Gap management—this technique requires setting the volume of interest-sensitive assets equal to the volume of interest sensitive liabilities. If interestrate raises the increase in interest revenues would match costs. Gap analysis is normally short-term oriented and does not consider reinvestment risk of intermediate cash flows and long-term profitability. Interest rate swaps—a swap is an agreement whereby two parties (counterparties) agree to exchange periodic payments. In an interest rate swap, the counterparties swap payments in the same currency based on an interest rate. Borrowing institutions exchange interest payments with one another for a specific period of time in order to save interest cost. Normally one party’s rate is floating (called reference rate) and the counterparty has a fixed rate.  Interest rate Futures—interest rate future contracts are classified by the maturity of their underlying security. Short-term interest rate futures contract have an underlying security that matures in one year or shorter and long-term interest rate futures depend on underlying securities with maturitymore than a year. Examples include 3-months Treasury bill, 3-month Eurodollar certificate of deposit--these contracts are traded in Chicago Mercantile Exchange. Long-term futures have underlying securities such as Treasury bond, U.S. government agency securities. As the date of future delivery gets closer the basis or the spread between the spot market and future market gets