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Trading the
Forward Rate Bias
The so-called Unbiased Expectations Hypothesis (UEH) suggests
that de-convexity-adjusted forward rates are unbiased predictors
of future spot rates. A well-known phenomenon in the front end of
the yield curve, however, is a systematic bias in forward rates: On
average, forward rates over-estimate future spot rates. While
academic research does not offer a conclusive explanation of the
forward rate bias puzzle, some of the recent work may be worth
reviewing.
The current slope of the money market curve, now implying some
25bp of Fed tightening until year-end, is at odds with what many
(maybe even the majority of) market participants expect. Some of
this disconnect is now attributed to the systematic bias in forward
rates. We discuss some basic trading strategies.
Fwdt represents the 1-year swap rate, 1-year forward, at time t, while
Spott+1 stands for the subsequently realized 1-year swap rate, 1 year
later. A regression of daily data going back 10 years yields the
following results:
very, very low. This suggests that the statistical model (1) explains only
very little of the variability in the data set.
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1y1y fwd minus subsequent 1y spot rate Average fwd minus spot
Fed Funds Target Rate
Spot rate bias An interesting question is whether spot rates make for a better
predictor of the future. To evaluate the forecasting accuracy of spot
rates, we consider the following model:
Spott represents the 1-year swap rate at time t, while Spott+1 stands for
the same 1-year swap rate, 1 year later. A regression of daily data
going back 10 years yields the following results:
What is striking is that the goodness of fit is even lower than with
forward rates (R-square of 15.8% vs. 17.3%), making spot an even
worse predictor of the future. The fact that spot rates also overestimate
future realized rates (although to a much smaller degree) indicates that
the time series chosen here (past 10 years) captures a drift lower in
yield (1-year swaps from 5.9% on 5/14/98 to 3.65% on 5/14/08). This
also affects the forward rate analysis (equation 1) and ideally one
should choose a period without such trend.
Combining spot and forward Often, practitioners expect realized rates in the future to come in
somewhere between spot and forward. To test this assumption, we
consider the following model:
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The Royal Bank of Scotland
While still not particularly high, the goodness of fit is higher than with
either spot or forward rates alone (R-square of 20.4% vs. 15.8% and
17.3%, respectively). The beta of 47% suggests that roughly the
average of spot and forward makes for the best predictor of the future.
Empirical evidence The results presented here appear consistent with the majority of
studies conducted in academic research. For example, Fama and Bliss
(1987) concluded that, over 1964-1985, 1-year forward rates on
Treasury bills contained information on expected returns on bills one
year in advance.1 When looking at the incremental informational value
of forward rates, studies suggest that forward rates produce better
one-step-ahead forecasts, as well as better once-and-for-all forecasts
of interest rates over a full year horizon than those obtained form the
own past of interest rates.2
While few, if any, studies suggest that forward rates are good
predictors of the future, there is widespread acknowledgement of some
informational value beyond what can be extracted from a history of
spot rates. However, there is also a “bias,” often vaguely attributed to a
term-risk premium, which greatly reduces the value of forward rates as
a signal.
Disconnect between
expectations and forwards
The current market environment suggests that there is somewhat of a
disconnect between what market participants would verbally express
in terms of rate expectations and what is implicitly priced into the
money market curve. This is maybe most obvious when looking at the
Fed fund target rate at year-end. A survey of 54 Street economists
conducted by Bloomberg between May 2 and May 8 resulted in an
average target rate of 1.94% (median of 2%). In other words, there
appears no widespread expectation of a Fed rate hike between now
and year-end. Fed fund futures contracts, on the other hand, implied a
roughly 30% chance of a 25bp hike during the survey period (since
then, this has increased to as high as 100%).
Main theme of 2008 Already for several months, market participants, for the most part, have
been skeptical about the Fed hiking implied for later this year and in
2009, given the fragile economy, the liquidity crisis in the financial
industry and the weak housing market. Year-to-date, it has been a
recurring market theme among many market strategists (including our
1
Fama, E., and Bliss, R., 1987, The information in long maturity forward rates, American Economic Review, 77, 680-692.
2
Dominguez, Emilio & Novales, Alfonso, 2002, Can Forward Rates Be Used to Improve Interest Rate Forecasts?, Applied Financial
Economics, Taylor and Francis Journals, Vol. 12(7), pages 493-504, July 2002.
3
The Royal Bank of Scotland
Chart 2: Fed tightening implied for 1yr period starting 8 months forward
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25 Forward getting it wrong
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Source: RBS Global Banking & Markets
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We highlighted this before in our 2/1/08 edition of U.S. Derivatives Strategy Weekly.
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The Royal Bank of Scotland
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P/L
$5,000
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ED1 to Exp ED2 to ED1 ED3 to ED2 ED4 to ED3
ED5 to ED4 ED6 to ED5 ED7 to ED6 ED8 to ED7
4
On the de-convexity adjustment of forward rates, see Gupta, Anurag & Subrahmanyam, Marti G., 2000, An empirical examination
of the convexity bias in the pricing of interest rate swaps, Journal of Financial Economics, Elsevier, vol. 55(2), pages 239-279,
February 2000.
5
The Royal Bank of Scotland
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2s10s spot slope minus de-conv.adj. fwd from a year before
Average spot minus forward slope
Fed Funds Target Rate
Source: RBS Global Banking & Markets
3. Receiver swaptions
A variation of an outright long position in Eurodollars is to structure the
trade conditionally through Eurodollar and Treasury future (and, to a
lesser extent, Fed fund future) calls, call spreads and call flies.
Similarly (and somewhat easier to analyze from an analytical point of
view), receiver swaptions can be utilized. In any case, the goal is to
explore the fact that strike levels for the options are biased to the
upside, due to the bias in forward rates.
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The Sharpe ratio measures the expected return per unit of risk. The risk is measured as the standard deviation of the P/L.
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The Royal Bank of Scotland
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Multiple
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2000 2001 2002 2003 2004 2005 2006 2007 2008
Because the payout ratio has the expected return in the numerator and
a risk measure (swaption price, which is a function of implied swaption
volatility) in the denominator, the fraction is essentially a Sharpe Ratio.
Thus, the attractiveness of receiver swaption trades based on this
payout ratio is inherently measured on a risk-adjusted basis.
Conditional curve trades The same way outright interest rate positions can be structured
bullishly through calls/receivers, curve steepeners can be expressed
conditionally as bull steepener trades. The analysis is similar, only that
the ratio between implied volatilities, not their outright level, is the
second essential driver of the trade (besides the forward rate bias).
Conditional curve steepeners, as a consequence, are often favored
when implied volatility is trading at elevated levels.
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Unfortunately, this is not often the case, as slope and vol are highly correlated with each other. There is little causation, though
(“correlation does not imply causation”). Rather, both are a function of general uncertainty.
7
The Royal Bank of Scotland
4. Receiver spreads
In a receiver spread, the purchase of an at-the-money-forward (ATMF)
Break-even rate Often, the attractiveness of receiver spreads is measured against the
break-even rate. This rate shows how much rates can drop before the
structure starts losing money (at swaption expiration) and can be
compared to what economic analyses suggest the likelihood of such a
rally would be.
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