Forecasting Interest Rates and
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 .
But do futures/forward rates really imply
the forward spot rate? And if so, what "market factors" drive such
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
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
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.
Back to Consulting ARBLab
 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.