Forecasting Interest Rates

# Forecasting Interest Rates - Econ 305 Forecasting Interest...

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Econ 305 Forecasting Interest Rates and Practice Quiz 2 Questions I. Forecasting Interest Rates The largest financial markets are those for bonds. The price of bonds is determined by current and forecast interest rates (“expected short rates”). In turn, the price of bonds determine the relative demand and prices for other assets. It is for this reason that forecasting interest rates is the central focus among financial analysts. The yield curve describes the valuation of bonds of different maturities. The yield curve for US government bonds summarizes the investment of more than 10 trillion dollars in debt. The big sophisticated investors, the so-called “smart money”, dominate this market. Using our theories of the term structure of interest rates, we can infer what the smart money believes about expected short rates. The Liquidity Premium Theory is our best theory for inferring the markets beliefs of expected short rates. It turns out that the market’s beliefs for expected short rates are the best forecast of expected short rates (consistent with the “efficient markets theory”.) United states government bond yields are listed at: . The following are US T-bill Yields for 02/13/2015 Tenor Coupon Price Last 1 Month 1 Year 3 Month 0.0000 0.0050 0.01% -2 -1 6 Month 0.0000 0.0600 0.06% -2 -1 12 Month 0.0000 0.2150 0.22% +6 +12 2 Year 0.5000 99-23¼ 0.64% +14 +33 5 Year 1.2500 98-20¼ 1.54% +22 +1 10 Year 2.0000 99-17½ 2.05% +20 -69 30 Year 2.5000 96-30½ 2.65% +18 -105 Change shown in basis points (last two columns) ‘Last’ gives the current yield on the T-bill. The 30 Year yield has increased by 18 basis points from a month ago. Thus a month ago it was 2.47%. It is down 105 basis points from a year ago; so a year ago the yield was 3.70%. (This implies a huge capital gain to bond holders.) The problems below took data from this source (and others) and summarize it as follows: Yield 02/13/14 Yield 02/13/15 12-Month 0.10 0.22 2-Year 0.31 0.64 30-Year 3.70 2.65 It appears that both curves are upward sloping (“normal”) yield curves. Last year’s curve is steeper and cuts the current yield curve from below. Using theories we can infer expected short rates for each curve. We can see how expectations have changed over the year. Exercise: What liquidity premium was needed last year ( l 2, t = l 2,2014 ) to correctly forecast the current interest rate ( i e t+ 1= i e 2015 =.22% = i 2015 )?

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Econ 305 II. Practice Quiz 2 Questions Below the data is given in percentages. If you do your calculation using percentages then indicate so with %. To use yields to calculate price or returns you need to convert from % to the equivalent fraction. Quiz 2, Spring 2015. Answer all parts of the following question . Show your work using the relationships used in class. The following are US government bond yields from Bloomsberg.com Yield 02/20/14 Yield 01/20/15 Yield 02/20/15 12-Month 0.10 0.16 0.21 2-Year 0.31 0.52 0.63 3-Year 0.66 0.86 0.95 (a) (2 marks) Roughly plot and briefly characterize the 02/20/15 yield curve and the yield curve for the previous month.
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