Forecasting Interest Rates and Funding Rates from Futures/Forwards Rates - 1

The ability to forecast interest rates either for outright trading or for funding capital is very valuable, but is it possible in a consistent and profitable manner?  A very common perception in the markets is that (deposit) futures and FRA forward rates "imply" the market's view (or at least expectation) of spot rates as of the futures/forward date [1].

But do futures/forward rates really imply the forward spot rate? And if so, what "market factors" drive such forecasts?

An approach to forecast verification

One approach is to back-test forward rates implied by real market prices against the actual interest rates that existed as of the expiration date of these derivatives over many periods.  Of course this is a big task, the software required to perform such analyses is necessarily complex, and importantly it must be aware of many real world implications such as idiosyncratic market data implications, transactions costs, and many other trading and market factors.  PaR is one implementation of this type of analysis (all of TG2RM1st - Chapter 12 is dedicated to the introduction of PaR analysis).

Please note, as ART Consulting/Research is a fee based service, in the following the results have been "sanitised" to disguise the specific markets, trading factors, strategy parameters and many other factors.  Of course all of the analyses is based on real market conditions and real world trading considerations.  For access to the "un-sanitised" results, and for analysis tailored to your needs please submit an email via  Request More Information.

Figure 1 illustrates the results for just this type of analysis.  Here 4 dimensions of IR forecasting from real world trading data spanning many years have been plotted  (there are 4,422 %net-difference points, representing the difference  between the trade date forward rate and the actual rate as of the forward expiration date).  The vertical axis is a measure of the difference, while the Y axis is a "market factor",  the X axis is the Days-to-Expiration, and the "colouring" of the results are due to yet other  "trading/market factors" (so the colouring is a "fourth dimension").

Clearly as the expiration date is approached, the implied forward rate and the spot rate converge, as it should be.  The question before us is "are there market conditions that are more forecast friendly than other market conditions?".

At first glance it seems that there is no appreciable pattern and so that there is no particular "forecastability".  However, on further examination two of the interesting observations include:

1) Whenever FactY is large, the range of the difference between the implied forward and the actual rate as of the forward date is generally smaller than at other times.  This implies that a high value of FactY leads to more "forecast friendly" conditions.

2) Another market factor, lets call it FactC (the colouring factor) also implies certain forecast friendly conditions.  For example, mostly when the marker colour is black, the implied forward rate appears to be a very good predictor of the actual rate as of the forward date.  Moreover, the "credibility" of FactC improves with shorter time to expiration.  Indeed, with less than 1-2 months to expiration the "black" FactC conditions appear to be quite a robust indicator of the actual spot rate as of the forward date.  In other words, whenever the market FactC condition holds as "black" (especially with shorter times to expiration), the current implied forward rate (from current traded derivatives) appears to provide a degree of forecast credibility in terms of the actual interest rate as of the forward date.

Clearly, one would not proceed to make trading decisions based purely on this single analysis.  At the very least additional analysis are required to further illustrate the impact of other factors, and to further quantify the (statistical and other) properties of the forecast "credibility".  

If you are interested in obtaining research results on this issue please Request More Information and please feel free to indicate a few specifics of interest to you.

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[1] In practice these derivatives are crucial to "lock-in" forward rates today so as to permit market makers to construct hedges and structured products.  This feature is of the highest importance to liquid markets and is to a large extent independent of the forecasting issue.  Nevertheless, the ability to forecast forward rates would invariably improve such hedging process efficiencies.