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An Adjusted Forward Curve for Spot Rate Forecasting

Received: 07 January 2020    Accepted: 31 January 2020    Published: 11 February 2020
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Abstract

In this paper, we provide adjustments for liquidity and credit risk to the forward Libor rate in order to improve accuracy of the forward rate in forecasting the 3-month Libor rate. In particular, we introduce the adjusted forward curve (AFC) that models the update in the forward curve from one period to the next. A direct modeling of the dynamic process of the forward curve facilitates the specification of adjustment factors to the forward curve, and it underscores the role of mean reversion (stationarity) in the nexus between the forward rate and the future spot rate. The AFC factors that underpin the forward curve bias are statistically relevant with p-values that are less than .00001. The upward bias in the forward curve (i.e., when the forward curve exceeds the expected future spot rate) positively correlates with the steepness of the yield curve in the AFC model. A downward bias positively correlates with the credit spread and industrial capacity utilization. Furthermore, the effect of the instantaneous forward curve on the future spot rate tempers off with time. The predictive power of the AFC model, however, hinges on the forecastability of the underlying factors. The testing indicates that all the AFC model factors have a mean reversion component. Overall, our model effectively anticipates movements in the forward curve that tend to yield a better forecast of the future spot rate.

DOI 10.11648/j.eco.20200901.11
Published in Economics (Volume 9, Issue 1, March 2020)
Page(s) 1-7
Creative Commons

This is an Open Access article, distributed under the terms of the Creative Commons Attribution 4.0 International License (http://creativecommons.org/licenses/by/4.0/), which permits unrestricted use, distribution and reproduction in any medium or format, provided the original work is properly cited.

Copyright

Copyright © The Author(s), 2024. Published by Science Publishing Group

Keywords

Adjusted Forward Curve, Forecasting Spot Rate, Yield Curve Steepness, Credit Risk, Mean Reversion

References
[1] Bauer, M. D. and G. D. Rudebusch (2015) “Monetary Policy Expectations at the Zero Lower Bound,” Federal Reserve Bank of San Francisco Working Paper Series.
[2] Bernanke, B. S. (1990) "On the Predictive Power of Interest Rates and Interest Rate Spreads," New England Economic Review, 51-68.
[3] Campbell, J. Y., and R. J. Shiller (1991) “Yield Spreads and Interest Rate Movements: A Bird’s Eye View.” Review of Economic Studies, 58, 495–514.
[4] Clark, T. E., and M. W. McCracken (2012) “Advances in Forecast Evaluation,” Handbook of Economic Forecasting, in: G. Elliott & C. Granger & A. Timmermann (ed.).
[5] Cochrane, J. H., and M. Piazzesi (2005) “Bond Risk Premia,” American Economic Review 95, 138-160.
[6] Duffee, G. (2013) "Forecasting Interest Rates,” Handbook of Economic Forecasting, in: G. Elliott & C. Granger & A. Timmermann (ed.).
[7] Estrella, A., and G. Hardouvelis (1991) “The Term Structure as a Predictor of Real Economic Activity,” Journal of Finance, 46, 555-576.
[8] Fama, E., (1984) "The Information in the Term Structure," Journal of Financial Economics, 13, 509-28.
[9] Fama, E and R. Bliss (1987) “The Information in Long-Maturity Forward Rates,” American Economic Review, 77, 680-92.
[10] Gibson, R., F. S. Lhabitant,. and D. Talay (2010) “Modeling the Term Structure of Interest Rates: A Review of the Literature, Foundations and Trends” in Finance, 5, p. 1-156.
[11] Gordon, R. J. (1997) ‘The Time-Varying NAIRU and its Implications for Economic Policy.” The Journal of Economic Perspectives 11, 11-32.
[12] Longstaff, F., and E. Schwartz (1995). “A Simple Approach to Valuing Risky Fixed and Floating Rate Exchange Rate,” Journal of Finance, 50, 789-819.
[13] Ludvigson, S. C., and S. Ng, (2009) “Macro Factors in Bond Risk Premia,” Review of Financial Studies 22, 5027-5067.
[14] Malkiel, B. G. (2003) “The Efficient Market Hypothesis and Its Critics.” Journal of Economic Perspectives, 17, 59-82.
[15] Piazzesi, M., and E. Swanson (2004) “Futures Prices as Risk Adjusted Forecasts of Monetary Policy.” NBER Working Paper No. 10547.
[16] Samuelson, P. A. (1965) “Rational Theory of Warrant Pricing,” Industrial Management Review, 6, 13 39.
[17] Shiller, R., Campbell, J. Y., and Schoenholtz, K. L. (1983) "Forward Rates and Future Policy: Interpreting the Term Structure of Interest Rates," Brookings Papers on Economic Activity, 173-217.
[18] Stock, J., and M. Watson (1989) "New Indexes of Coincident and Leading Economic Indicators." NBER Macroeconomics Annual 1989, Olivier J. Blanchard and Stanley Fischer, eds., 351-94. Cambridge, Mass.: The M. I. T. Press.
[19] Wu, J. C., and F. D. Xia (2016) “Measuring the Macroeconomic Impact of Monetary Policy at the Zero Lower Bound.” Journal of Money, Credit and Banking, 48, 253-291.
Author Information
  • The Office of Risk Management, Inter-American Development Bank, Washington DC, USA

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    Camilo Sarmiento. (2020). An Adjusted Forward Curve for Spot Rate Forecasting. Economics, 9(1), 1-7. https://doi.org/10.11648/j.eco.20200901.11

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  • @article{10.11648/j.eco.20200901.11,
      author = {Camilo Sarmiento},
      title = {An Adjusted Forward Curve for Spot Rate Forecasting},
      journal = {Economics},
      volume = {9},
      number = {1},
      pages = {1-7},
      doi = {10.11648/j.eco.20200901.11},
      url = {https://doi.org/10.11648/j.eco.20200901.11},
      eprint = {https://download.sciencepg.com/pdf/10.11648.j.eco.20200901.11},
      abstract = {In this paper, we provide adjustments for liquidity and credit risk to the forward Libor rate in order to improve accuracy of the forward rate in forecasting the 3-month Libor rate. In particular, we introduce the adjusted forward curve (AFC) that models the update in the forward curve from one period to the next. A direct modeling of the dynamic process of the forward curve facilitates the specification of adjustment factors to the forward curve, and it underscores the role of mean reversion (stationarity) in the nexus between the forward rate and the future spot rate. The AFC factors that underpin the forward curve bias are statistically relevant with p-values that are less than .00001. The upward bias in the forward curve (i.e., when the forward curve exceeds the expected future spot rate) positively correlates with the steepness of the yield curve in the AFC model. A downward bias positively correlates with the credit spread and industrial capacity utilization. Furthermore, the effect of the instantaneous forward curve on the future spot rate tempers off with time. The predictive power of the AFC model, however, hinges on the forecastability of the underlying factors. The testing indicates that all the AFC model factors have a mean reversion component. Overall, our model effectively anticipates movements in the forward curve that tend to yield a better forecast of the future spot rate.},
     year = {2020}
    }
    

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  • TY  - JOUR
    T1  - An Adjusted Forward Curve for Spot Rate Forecasting
    AU  - Camilo Sarmiento
    Y1  - 2020/02/11
    PY  - 2020
    N1  - https://doi.org/10.11648/j.eco.20200901.11
    DO  - 10.11648/j.eco.20200901.11
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    JF  - Economics
    JO  - Economics
    SP  - 1
    EP  - 7
    PB  - Science Publishing Group
    SN  - 2376-6603
    UR  - https://doi.org/10.11648/j.eco.20200901.11
    AB  - In this paper, we provide adjustments for liquidity and credit risk to the forward Libor rate in order to improve accuracy of the forward rate in forecasting the 3-month Libor rate. In particular, we introduce the adjusted forward curve (AFC) that models the update in the forward curve from one period to the next. A direct modeling of the dynamic process of the forward curve facilitates the specification of adjustment factors to the forward curve, and it underscores the role of mean reversion (stationarity) in the nexus between the forward rate and the future spot rate. The AFC factors that underpin the forward curve bias are statistically relevant with p-values that are less than .00001. The upward bias in the forward curve (i.e., when the forward curve exceeds the expected future spot rate) positively correlates with the steepness of the yield curve in the AFC model. A downward bias positively correlates with the credit spread and industrial capacity utilization. Furthermore, the effect of the instantaneous forward curve on the future spot rate tempers off with time. The predictive power of the AFC model, however, hinges on the forecastability of the underlying factors. The testing indicates that all the AFC model factors have a mean reversion component. Overall, our model effectively anticipates movements in the forward curve that tend to yield a better forecast of the future spot rate.
    VL  - 9
    IS  - 1
    ER  - 

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