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Case I – Fixed Income - PIMCO

How well do forward rates forecast future spot rates

Faculdade de Economia
Universidade NOVA de Lisboa
Investments
Professor Pedro Santa-Clara
Henrique Almeida Johannes Ebe
MST16000347 MST16000308

Christian Narvaez Oliver Wolf
MST16000283 MST16000366

22 September 2010

II

Table of contents
1 Problem set and introduction .................................................................................... 3
2 Calculation of expected future spot rates (forward rates) .......................................... 3
3 Analysis of yield development over time ................................................................... 4
4 Conclusions ............................................................................................................... 5
Appendix .......................................................................................................................... 8



Investments Case I: Fixed Income – How well do forward rates forecast future spot rates

3
1 Problem set and introduction
The estimation of interest rates is a commonly used tool in different areas of the financial
sector e.g. risks management, portfolio management or the pricing of derivates. Therefore
current forward rates are used as a rough estimation for yet unknown future interest rates
1
.
Even so it is common practice to derive future spot rates from current forward rates this has
to be done with care especially when relying investments decision on the methods outcome.
For that purpose to question if this approach is an adequate measurement might be best
answered by looking at historical data – as it will be done in the following analysis. The
analysis therefore includes the different yields with a maturity between 1 and 5 years of US
Zero Bonds at the end of each year between 1952 and 2005. After the calculation of the
expected future spot rates (forward rates), the analysis will compare the results with the
actual occurred yields. Finally, the conclusions points out the validity and accurateness as
well as possible restrictions of this approach.
2 Calculation of expected future spot rates (forward rates)
Since the yields to maturity we have are derived from zero bonds they represent the
different spot rates across all given maturities. With the help of these spot rates all forward
rates can be easily computed by the following formula:
( ) √
(

)

(

)

-1
where,
( )= the forward rate from year a to year b

= the spotrate until year b

= the spotrate until year a
C=

1
Bodie, Kane, Marcus; “Investments”; McGraw Hill; Fifth Edition
Investments Case I: Fixed Income – How well do forward rates forecast future spot rates

4

Example calculation:
Calculation of () of the year 1952
()

()

( ())

( ())

()

()

() √
()

()

() 0.02221
3 Analysis of yield development over time
In order to forecast future spot rates, we compared the precision of two different predictors:
The forward rates and today’s spot rates.
For both of these predictors we computed the average forecast error across all available
maturities of the spot rates with the formulas:
Spot rate as predictor (1 year maturity):
|

||

||

|

Forward rates as predictor (1year maturity):
|

()||

()||

()|

Where,
t = no of observed spot rates

spot rate or year “t”
f(1,2) = forward rate from time “t-1” to time “t”
The results of our calculation allow for two different assumptions:
Forward rates (calculated)
Spot rates (with different maturity)
Investments Case I: Fixed Income – How well do forward rates forecast future spot rates

5
1. Which of the two predictors has on average a higher forecast error (higher difference
between prediction and actual spot rate)
2. How does each of the predictors behave as maturity increases? So to say, will the
average forecast error increase or decrease as time to maturity of the observed spot
rates increases?
Additionally, the following graph (the ones for yield 2 to 4 can be found in Appendix 2)
compares exemplary the spot rate in t=1 with the spot rate t=0 and the corresponding
forward rates (time and maturity). This will support our analytical analysis of the calculated
forecasting errors, and allows verifying the conclusions in a simple graphical way.

4 Conclusions
First, from a theoretical point of view, forward should already include all our expectations
regarding future economic development according to the “theory of expectations”
2
.
Consequently this negates that there are any liquidity premiums included in long term

2,3
Bodie, Kane, Marcus; “Investments”; McGraw Hill; Fifth Edition
0
2
4
6
8
10
12
14
16
1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Yield 1
yield1 yield1 (n-1) f(1,2) f(2,3) f(3,4) f(4,5)
Investments Case I: Fixed Income – How well do forward rates forecast future spot rates

6
bonds. On the other hand the “liquidity preference theory”
3
assumes that investors prefer
more liquid assets and therefore are in favour of short term bonds. This subsequently leads
to a liquidity premium demand in order to invest in long term bonds. As these theories
demonstrate ambiguity the assumption can be made that not all expectations are reflected
in today’s interest rates by market participants and therefore influence the accurateness of
the forward rates as predictors for future spot rates.

As we can see from our analysis the forward rates are not very reliable predictors for future
spot rates. Our calculations proofed that the average forecast error (AFE) (appendix 3) is
more than one percent for all maturities. In fact today’s spot rates turned out to be more
exact in forecasting future spot rates than the forward rates. From a theoretical point of
view and in line with the assumptions of efficient markets the forward rate should contain all
available information about the future spot rate expectation. So we have to ask the
question, what might be possible reasons for the poor performance of the forward rate as a
forecast instrument. One of the reasons certainly is the information deficit. At the time
forward rates are calculated all available information that could be influencing future spot
rates is incorporated in the forward rate. However no one knows what will really happen
and in the end those are only investor’s expectations and they tend to be biased by
irrationality as well. Furthermore we also have to consider that markets are never 100
percent efficient or rational. Irrationality, wrong expectations and insufficiency of
information always have to be taken into account in a human environment.
The AFE is decreasing with longer maturities due to the higher “root” we must use in order
to compute the Forward. For example The AFE for ƒ(1,3) is higher than the AFE for ƒ(1,5),
because on the second one we must use 4-root, and on the first one we use squared-root,
which lead us at the end to get lower values.



Investments Case I: Fixed Income – How well do forward rates forecast future spot rates

7
This doesn´t mean that forwards for longer maturities are better predictors than the shorter
ones. In fact, as we said before, including for 1-year Forwards is better to use Spots in order
to predict future spots.
We also computed the correlation (appendix 4), between each forward rate with the
respective yield is positive. This means that as one variable becomes large, the other also
becomes large, and vice versa.
Although, we squared the coefficient of correlation, in order to achieve the percentage of
the variation in one variable that is related to the variation in the other.
Therefore, we can conclude that the coefficient of correlation increases the further away we
go back in time to determine forward rates, and this proves that usually shorter forward
rates are better forecasters of the future spot rates.
Investments Case I: Fixed Income – How well do forward rates forecast future spot rates

8
Appendix
Appendix 1 Calculated forward rates in comparison with historical spot rates
historical historical calculated forwards
date yield1 yield1 (n-1) f(1,2) f(2,3) f(3,4) f(4,5)
1952 1,998
1953 1,574 1,998 2,384365193
1954 1,139 1,574 2,026502845 2,251011743
1955 2,653 1,139 1,828170033 2,286773809 1,80361033
1956 3,444 2,653 2,597007637 2,17456499 1,914008473 2,609980305
1957 2,686 3,444 3,706165897 3,165947691 2,821501719 3,26675043
1958 2,954 2,686 2,406190873 3,467037534 2,110765003 2,174134279
1959 4,86 2,954 3,288270888 2,996658562 3,495007011 3,478787469
1960 2,635 4,86 4,980034331 4,658579313 3,241081581 4,209788918
1961 3,109 2,635 2,927207687 5,124132244 4,0235564 2,797004765
1962 2,978 3,109 3,659733447 3,771162739 4,556666133 3,899111481
1963 3,829 2,978 3,430495989 4,349993141 4,061273501 4,535453649
1964 4,05 3,829 3,987060108 3,732900942 3,793028006 3,782733004
1965 4,886 4,05 3,816131562 3,959008344 3,496048819 4,338436609
1966 5,013 4,886 4,730058006 4,059050924 4,257397941 3,819650749
1967 5,944 5,013 4,567473551 5,054192516 4,071033244 3,988001538
1968 6,487 5,944 5,45855736 5,048211796 4,842008237 4,384570524
1969 8,024 6,487 6,101349799 5,725001816 4,305168833 4,339111005
1970 4,883 8,024 8,200071688 5,581597505 5,629022701 4,488229142
1971 4,179 4,883 5,9175386 8,2470562 6,866311373 5,189945277
1972 5,525 4,179 5,477018171 6,500817239 8,289060424 6,613474728
1973 7,124 5,525 6,308448766 5,5777901 5,941109859 7,084545982
1974 6,875 7,124 6,255766411 6,135150975 5,572878684 6,35512403
1975 5,974 6,875 7,463808758 6,515094576 6,273285497 6,329822566
1976 4,768 5,974 7,257865099 7,097016123 6,735038044 6,596080573
1977 6,835 4,768 5,832691289 7,61914234 7,129000896 6,782058613
1978 10,142 6,835 7,327566444 6,45218428 7,633642229 6,896223995
1979 11,156 10,142 9,118389361 7,330193053 6,03844996 8,299166804
1980 12,811 11,156 10,51692123 8,832934673 7,801416857 7,370589442
1981 12,9 12,811 11,97455624 9,455769265 8,283022553 7,949457582
1982 8,491 12,9 13,51684025 11,14563576 9,341640864 8,702557296
1983 9,803 8,491 10,05459347 14,01089064 11,98300021 9,327263834
1984 9,018 9,803 11,2598002 10,97074833 13,79934708 11,48785693
1985 7,479 9,018 10,55941034 11,17525546 11,11556976 12,96722491
1986 6,06 7,479 8,226294476 11,59585524 12,4457189 10,72418104
1987 7,242 6,06 6,532525137 8,775624108 11,44982317 12,13535655
1988 8,896 7,242 8,037469657 6,92423362 9,267232972 12,27039767
1989 7,757 8,896 8,974013967 8,384715491 7,037997346 9,37826512
1990 6,918 7,757 7,713004492 9,088071641 8,805920569 8,020110062
1991 4,171 6,918 7,190172992 7,897081213 9,006001376 9,059274771
1992 3,651 4,171 5,291999693 7,814795153 7,793000056 9,041009176
1993 3,636 3,651 5,355954115 6,076731689 7,960487093 7,640083472
1994 7,142 3,636 4,771091165 6,647545478 7,646449501 8,403224707
Investments Case I: Fixed Income – How well do forward rates forecast future spot rates

9
1995 5,086 7,142 7,851169625 4,989977933 7,103635101 6,430550618
1996 5,456 5,086 5,076000238 8,021855147 6,389163298 7,543999512
1997 5,411 5,456 6,117032658 5,384291326 7,767032103 6,283810487
1998 4,438 5,411 5,737252051 6,347992275 5,614665817 7,560067674
1999 5,893 4,438 4,59806128 5,727073922 6,389612783 5,350013678
2000 5,428 5,893 6,39559495 4,758183747 5,717030054 6,38736259
2001 2,052 5,428 4,659405936 6,363150651 4,826186438 5,553034164
2002 1,209 2,052 4,086035511 5,172052814 6,533352717 4,320428659
2003 1,227 1,209 1,95637467 5,321281839 4,922095954 6,746762669
2004 2,749 1,227 2,450675897 2,941015889 5,485028925 4,755320067
2005 4,389 2,749 3,35188177 3,456509948 3,759852807 5,291320906

historical historical calculated forwards
date yield2 yield2 (n-1) f(1,3) f(2,4) f(3,5)
1952 2,191
1953 1,8 2,191 2,317666743
1954 1,483 1,8 2,156555438 2,027065798
1955 2,625 1,483 2,001220468 2,100221022 2,206000073
1956 3,575 2,625 2,88108438 2,497522945 2,588149795
1957 2,546 3,575 3,586532712 2,637000351 2,497306908
1958 3,121 2,546 2,701000365 3,481021328 2,792500456
1959 4,92 3,121 3,971167594 3,118797652 3,851783012
1960 2,781 4,92 5,05205858 4,34058476 3,018803891
1961 3,384 2,781 3,348323737 4,84001525 3,96131532
1962 3,204 3,384 4,004290653 3,91611688 4,546059353
1963 3,908 3,204 3,581588107 4,071137981 3,921909932
1964 3,933 3,908 3,97303328 3,614407203 4,065374996
1965 4,808 3,933 3,937520275 4,108096239 3,657723506
1966 4,79 4,808 4,892000057 4,065041912 4,122612613
1967 5,701 4,79 4,807567038 4,948046752 4,227683986
1968 6,294 5,701 5,591695547 4,676031005 4,590257363
1969 8,112 6,294 5,84115461 5,677001362 4,396658863
1970 5,399 8,112 8,223561394 6,222012193 5,40925537
1971 4,826 5,399 6,208777513 8,268056275 6,739818189
1972 5,916 4,826 5,527392107 6,220594892 7,685119076
1973 6,689 5,916 6,221764529 5,575334364 6,147915094
1974 7,169 6,689 6,385351475 6,204195778 5,950674647
1975 6,614 7,169 7,280255682 6,625009598 6,434560663
1976 5,299 6,614 7,438351864 7,113007316 6,75854574
1977 7,081 5,299 6,14198583 7,62639204 7,012549152
1978 9,629 7,081 7,32887974 6,245115728 7,965891713
1979 10,836 9,629 8,975568551 7,565546913 6,702440814
1980 12,392 10,836 9,985065485 8,557630408 7,875411825
1981 13,208 12,392 11,55932611 9,398690182 8,492587135
1982 9,27 13,208 13,76359725 11,56353236 9,334452113
1983 10,529 9,27 10,51172152 13,90506975 11,7351543
1984 9,786 10,529 11,2175198 11,04313544 13,38252262
1985 7,852 9,786 11,07642392 11,80868269 10,91970277
1986 6,296 7,852 8,500611641 11,5228153 12,2904305
1987 7,639 6,296 6,728199675 9,021151439 11,85935798
1988 8,935 7,639 8,210953286 6,981100361 9,32273495
1989 7,735 8,935 9,03102789 8,595113816 7,527932437
Investments Case I: Fixed Income – How well do forward rates forecast future spot rates

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1990 7,054 7,735 7,805003563 9,047028788 8,932524014
1991 4,73 7,054 7,502030416 7,845028078 9,023503871
1992 4,5 4,73 5,683637335 7,88761653 7,716514629
1993 4,202 4,5 5,999782584 6,858708307 8,18162941
1994 7,496 4,202 4,880477447 6,875346995 7,036773553
1995 5,081 7,496 7,936478647 5,687255177 7,323591447
1996 5,786 5,081 5,230032882 7,894368395 6,336473845
1997 5,574 5,786 6,232449701 5,499415689 7,663500157
1998 4,518 5,574 5,732162864 6,368800493 5,482256747
1999 6,144 4,518 4,678091897 5,722051869 6,388487681
2000 5,043 6,144 6,379371563 4,792179577 5,635000284
2001 3,064 5,043 4,915416258 6,448217667 4,573001793
2002 1,582 3,064 4,70183705 5,047000038 6,640004308
2003 1,837 1,582 2,447512341 5,403123583 4,838674847
2004 3,05 1,837 2,952364568 3,349623398 5,38813041
2005 4,323 3,05 3,475854287 3,856918055 3,97902277

historical historical calculated forwards
date yield3 yield3 (n-1) f(1,4) f(2,5)
1952 2,211
1953 1,962 2,211 2,146026837
1954 1,713 1,962 2,07564238 2,221001761
1955 2,805 1,713 2,273917853 2,487592599
1956 3,539 2,805 2,623667714 2,389613155
1957 2,696 3,539 3,556015155 2,916832422
1958 3,631 2,696 2,880712782 3,723375816
1959 4,988 3,631 3,988627597 3,011421586
1960 3,11 4,988 4,886667514 4,193218965
1961 3,705 3,11 3,585429266 4,738396251
1962 3,38 3,705 3,933822035 3,871636551
1963 3,925 3,38 3,553067159 4,16016135
1964 3,975 3,925 4,067735217 3,682776596
1965 4,89 3,975 3,982005556 4,068049269
1966 4,876 4,89 4,875333469 4,171442623
1967 5,709 4,876 4,63983267 4,744674321
1968 6,056 5,709 5,604136466 4,613392909
1969 8,157 6,056 6,181776155 5,514399271
1970 5,765 8,157 8,245390001 6,352339736
1971 5,076 5,765 6,119479904 7,872106572
1972 5,989 5,076 5,542552121 6,26541902
1973 6,631 5,989 6,238935409 5,826233697
1974 7,145 6,631 6,501786185 6,334663702
1975 6,948 7,145 7,229813706 6,677333588
1976 5,682 6,948 7,50340925 7,040697405
1977 7,164 5,682 6,107462646 7,85018463
1978 9,363 7,164 7,486161516 6,618956669
1979 10,374 9,363 8,744229132 7,693365192
1980 11,975 10,374 9,770171013 8,605917889
1981 13,475 11,975 11,70037241 9,374876216
1982 9,834 13,475 13,77551261 11,53830151
1983 10,744 9,834 10,71263877 13,59159288
1984 10,386 10,744 11,62542165 10,93671534
Investments Case I: Fixed Income – How well do forward rates forecast future spot rates

11
1985 8,159 10,386 11,20075113 11,9174681
1986 6,505 8,159 8,755552588 11,77145467
1987 7,887 6,505 6,83136581 9,140059594
1988 8,986 7,887 8,408913347 7,326321722
1989 7,789 8,986 9,02268508 8,749614219
1990 7,307 7,789 7,801002246 9,045022214
1991 5,177 7,307 7,654632583 7,77666989
1992 5,211 5,177 6,333898853 8,059212852
1993 4,464 5,211 6,366463516 6,715798038
1994 7,671 4,464 5,380980467 7,09776796
1995 5,182 7,671 7,879966883 5,885733974
1996 5,973 5,182 5,358087966 7,782819534
1997 5,625 5,973 6,284811581 5,449591492
1998 4,598 5,625 5,727118354 6,374987499
1999 6,217 4,598 4,727433483 5,665682584
2000 5,086 6,217 6,43067387 4,63469271
2001 3,811 5,086 4,917642776 6,547639779
2002 2,033 3,811 4,962252762 4,949683253
2003 2,374 2,033 2,883104463 5,36584284
2004 3,233 2,374 3,386038967 3,631862685
2005 4,317 3,233 3,688736942 4,221378435

historical historical calculated forwards
date yield4 yield4 (n-1) f(1,5)
1952 2,109
1953 1,95 2,109 2,261818166
1954 1,989 1,95 2,37212517
1955 2,631 1,989 2,248962827
1956 3,528 2,631 2,83678288
1957 2,832 3,528 3,719073068
1958 3,729 2,832 2,859779389
1959 4,88 3,729 3,96624134
1960 3,347 4,88 4,798753578
1961 3,727 3,347 3,634720007
1962 3,409 3,727 4,034828341
1963 4,008 3,409 3,619648814
1964 3,999 4,008 4,047796067
1965 4,878 3,999 4,082501015
1966 4,733 4,878 4,741020051
1967 5,689 4,733 4,601911179
1968 6,258 5,689 5,500436022
1969 8,19 6,258 6,289536644
1970 5,809 8,19 7,954004537
1971 5,2 5,809 6,178341943
1972 6,06 5,2 5,738821572
1973 6,657 6,06 6,328109362
1974 7,141 6,657 6,57178525
1975 7,119 7,141 7,146318809
1976 5,771 7,119 7,701798793
1977 7,323 5,771 6,421844379
1978 9,092 7,323 7,601798789
1979 10,115 9,092 8,733809676
Investments Case I: Fixed Income – How well do forward rates forecast future spot rates

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1980 11,977 10,115 9,659276285
1981 13,556 11,977 11,64720559
1982 10,153 13,556 13,57290011
1983 11,167 10,153 10,71552422
1984 10,651 11,167 11,75268756
1985 8,435 10,651 11,46720355
1986 6,638 8,435 8,910897565
1987 8,116 6,638 7,127319782
1988 8,991 8,116 8,571139201
1989 7,79 8,991 9,027265815
1990 7,47 7,79 7,760750013
1991 5,789 7,47 7,841294574
1992 5,681 5,789 6,358053563
1993 4,942 5,681 6,659633224
1994 7,695 4,942 5,605966436
1995 5,29 7,695 7,799902995
1996 6,077 5,29 5,356069336
1997 5,648 6,077 6,310440062
1998 4,655 5,648 5,683570408
1999 6,296 4,655 4,62553365
2000 5,045 6,296 6,509608213
2001 4,227 5,045 4,877038533
2002 2,462 4,227 5,044423256
2003 2,842 2,462 3,210426888
2004 3,453 2,842 3,775854151
2005 4,312 3,453 3,840153869

Investments Case I: Fixed Income – How well do forward rates forecast future spot rates

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Appendix 2 Graphical illustration and comparison of spot and forward rates



0
2
4
6
8
10
12
14
16
1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Yield 2
yield2 yield2 (n-1) f(1,3) f(2,4) f(3,5)
0
2
4
6
8
10
12
14
16
1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Yield 3
yield3 yield3 (n-1) f(1,4) f(2,5)
0
2
4
6
8
10
12
14
16
1952 1954 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
Yield 4
yield4 yield4 (n-1) f(1,5)
Investments Case I: Fixed Income – How well do forward rates forecast future spot rates

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Appendix 3


Term yield 1 1-2 2-3 3-4 4-5 yield 2 1-3
Mean 5,4636 5,9115 6,2723 6,4146 6,5392 5,6715 6,0663
Average Forecast Error 1,2380 1,4247 1,8943 2,1067 2,0488 1,2030 1,3033
Term 2-4 3-5 yield 3 1-4 2-5 yield 4 1-5
Mean 6,3224 6,4535 5,8423 6,1540 6,3692 5,9543 6,2208
Average Forecast Error 1,6679 1,7169 1,1399 1,1791 1,4823 1,0815 1,0962


4.8
5
5.2
5.4
5.6
5.8
6
6.2
6.4
6.6
6.8
Yield
1
f(1,2) f(2,3) f(3,4) f(4,5) Yield
2
f(1,3) f(2,4) f(3,5) Yield
3
f(1,4) f(2,5) Yield
4
f(1,5)
Rates Average
0
0.5
1
1.5
2
2.5
Average Forecast Error
Investments Case I: Fixed Income – How well do forward rates forecast future spot rates

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Appendix 4







0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
f(1,2) f(2,3) f(3,4) f(4,5) f(1,3) f(2,4) f(3,5) f(1,4) f(2,5) f(1,5)
Correlation
Investments Case I: Fixed Income – How well do forward rates forecast future spot rates

16



0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
f(1,2) f(2,3) f(3,4) f(4,5) f(1,3) f(2,4) f(3,5) f(1,4) f(2,5) f(1,5)
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.................................................. 3 Analysis of yield development over time ........................................................... 4 Conclusions ........................ 5 Appendix ......... 8 II ............. 3 Calculation of expected future spot rates (forward rates) ...........................................................................................................................................................................................................................................Table of contents 1 2 3 4 Problem set and introduction .....................................

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