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
MST16000347

Johannes Ebe
MST16000308

Christian Narvaez
MST16000283

Oliver Wolf
MST16000366

22 September 2010

Table of contents
1

Problem set and introduction .................................................................................... 3

Calculation of expected future spot rates (forward rates) .......................................... 3

Analysis of yield development over time ................................................................... 4

Conclusions ............................................................................................................... 5

Appendix .......................................................................................................................... 8

II

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

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 rates1.
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:
(

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

-1

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

Spot rates (with different maturity)

Forward rates (calculated)

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 todays 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:

)|

)|

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

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.
Yield 1
16
14
12
10
8
6
4
2
0
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

yield1

yield1 (n-1)

f(1,2)

f(2,3)

f(3,4)

f(4,5)

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 expectations2.
Consequently this negates that there are any liquidity premiums included in long term

2,3

Bodie, Kane, Marcus; Investments; McGraw Hill; Fifth Edition

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

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 todays 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 todays 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 investors 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 (1,3) is higher than the AFE for (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

This doesnt 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

Appendix

Appendix 1

Calculated forward rates in comparison with historical spot rates

historical

historical

date

yield1

yield1 (n-1)

f(1,2)

calculated forwards

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

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

f(2,3)

f(3,4)

f(4,5)

2,609980305

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

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

date

yield2

yield2 (n-1)

f(1,3)

calculated forwards

1952

2,191

f(2,4)

f(3,5)

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

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

yield3 (n-1)

f(1,4)
2,146026837

date

yield3

1952

2,211

1953

1,962

2,211

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

10

f(2,5)

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

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

date

yield4

yield4 (n-1)

calculated forwards
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

11

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

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

12

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

Appendix 2

Graphical illustration and comparison of spot and forward rates

Yield 2

16
14
12
10
8
6
4
2
0
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

yield2

yield2 (n-1)

f(1,3)

f(2,4)

f(3,5)

Yield 3
16
14
12
10
8
6
4
2
0
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
yield3

yield3 (n-1)

f(1,4)

f(2,5)

Yield 4
16
14
12
10
8
6
4
2
0
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
yield4

yield4 (n-1)

13

f(1,5)

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

Appendix 3

Rates Average
6.8
6.6
6.4
6.2
6
5.8
5.6
5.4
5.2
5
4.8
Yield f(1,2)f(2,3) f(3,4)f(4,5)
1

Yield f(1,3)f(2,4)f(3,5)
2

Yield f(1,4) f(2,5)

3

Yield f(1,5)
4

Average Forecast Error

2.5
2
1.5
1
0.5
0

Term
Mean
Average Forecast Error
Term
Mean
Average Forecast Error

yield 1
5,4636
1,2380
2-4
6,3224
1,6679

1-2
5,9115
1,4247
3-5
6,4535
1,7169

2-3
6,2723
1,8943
yield 3
5,8423
1,1399

14

3-4
6,4146
2,1067
1-4
6,1540
1,1791

4-5
6,5392
2,0488
2-5
6,3692
1,4823

yield 2
5,6715
1,2030
yield 4
5,9543
1,0815

1-3
6,0663
1,3033
1-5
6,2208
1,0962

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

Appendix 4

Correlation
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
f(1,2) f(2,3) f(3,4) f(4,5)

f(1,3) f(2,4) f(3,5)

15

f(1,4) f(2,5)

f(1,5)

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

R2
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
f(1,2) f(2,3) f(3,4) f(4,5)

f(1,3) f(2,4) f(3,5)

16

f(1,4) f(2,5)

f(1,5)