Mastering finance : the complete finance companion by None

Author:None
Language: eng
Format: epub
Tags: Finance, Finances, Entreprises -- Finances, Marché financier, Finance, Entreprises -- Finances, Marché financier, Investissement de capitaux, Finance
ISBN: 9780273630913
Publisher: London : FT Pitman
Published: 1998-08-05T16:00:00+00:00

What do forward rates forecast?

While forward rates provide a valuable tool to calibrate the relative desirability of holding short-term bonds versus long-term bonds, forward rates could also serve as a useful way to forecast future interest rates or bond returns.

Returning to our example, the current one-year yield is seven per cent and the two-

year yield is eight per cent. If bond investors anticipated an increase in interest rates and if bond investors wanted bonds of all maturities to earn approximately the same as the one-year yield of seven per cent, then the current forward rate of 9.01 per cent could be a forecast of short-term interest rates to be observed in one year. We could think of this 9.01 per cent as a forecast that is implicit in current bond market yields (or prices) and which represents a consensus view among bond investors who are competing among one another in determining market prices for bonds.

Alternatively, bond investors may anticipate that the yield curve will not change over the next year and may desire that bonds of different maturities earn different expected rates of return. Under these assumptions the forward rate of 9.01 per cent is a forecast of the return on buying a two-year bond and selling it in one year when it has one year until it matures. Thus, the forward rate is not forecasting future interest rates but holding period returns.

Most evidence suggests that forward rates are not good predictors of interest rates to be observed in the near term. For example, forward rates are on average too high relative to future interest rates. This suggests that bond investors expect to earn on average a premium for holding long-term bonds relative to short-term bonds.

More surprising is the evidence suggesting that when forward rates are high (that is, the yield on long-term bonds is above the yield on short-term bonds), future yields on long-term bonds are more likely to go down, not up. While this evidence is based primarily on US data, there is some support in the data from other countries. Furthermore, the academic research that supports this conclusion has a long history, dating back more than 60 years.

Consider the implications of this empirical finding for investment strategies. When long-term bonds offer a yield advantage over short-term bonds, they are also likely to generate a capital gain from decreases in future interest rates. Such behavior could justify a bond investment strategy known as riding the yield curve’ - an investment policy of lengthening the maturity of the bond portfolio whenever yields on long-term bonds exceed the yields on short-term bonds.

Table 1 provides a summary of the potential returns from buying long-term bonds when their yield is high relative to short-term bonds. While long-term bonds may not offer on average a return significantly more than short-term bonds, there are nevertheless periods when an investor could expect a substantial profit from investing in long-term bonds — namely when the yield curve is steeply upward-sloping.

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