Home / Banking Strategies / Betting on Forward Implied Yields

Betting on Forward Implied Yields

Apr 13, 2012 / Consumer Banking

An astonishing number of bankers (rookies and veterans alike) express the view that the forward implied yield is just another generally inaccurate method of predicting future interest rates.

Those who dismiss “forward implied yield” by citing its statistical inaccuracy for predicting the future of interest rates miss the most important point. The forward implied yield provides those who make financial commitments over time – such as bankers – the ability to recognize the risks and opportunities embedded in their “bets.”

Consider sports betting. Yes, the NFL champion New York Giants are likely considered favorites in most of their games next season because of the strength of their team and their recent performances. So, I want to bet on them, right? Any takers?

I am pretty confident I can pick the winners. But, I will not be able to turn that into financial gain unless I can more accurately predict the magnitude of the wins compared to other interested and willing counterparties. Due to the fact that many people will likely have similar general “underwriting” of these games, I will have to provide some points to get people to bet with me. In fact, I may well believe the Giants will win games, but take the other team because I don’t think the Giants will cover the point spread. Point spreads balance the perceived economic value of the positions of the counterparties so that the market attracts enough people on each side of the transaction to satisfy the market for these bets.

Fixed-rate financial instruments experience the same phenomenon. When everyone determines rates will rise, the market demands a premium for longer-term investments. That premium monetizes the market’s aggregate expectations of future interest rates. To be successful in creating and preserving value in the fixed-income markets, you must compare the forward implied yields associated with your commitments against the ultimate interest rate results over time. The forward implied yields should never be treated as just another forecast opinion. There is real power in recognizing that the forward implied yields strike the point spread that you need to measure your funding and investment decisions against.

Account for Opportunity Costs

In my years as a banker I have been amazed at the superficial assessments developed by many bankers for managing fixed-rate assets and liabilities. Yes, I know there is a general logic behind keeping your investments short when you anticipate interest rates will rise so that you can re-price as rates rise. However, that analysis ignores opportunity costs; successful bankers do not allow their thinking to stop there.

Accurately predicting the general direction of interest rates is no more financially valuable than predicting the NFL champions will defeat the least competitive team in the league. It provides absolutely no financial benefit unless the accuracy of the forecast extends to not only direction, but also magnitude.

If the market’s forward implied yield path proves to be precisely accurate, in the long-run it doesn’t economically matter what investment or funding terms you select. This is because the market has priced the alternative investments to make the long- and short-terms financially equivalent. This is the calculation behind forward implied yields.

Assume today that you can buy two investments: five years at 4% or two years at 2.5%. So, today you can lock in $100 x 4% for five years = $20. Alternatively, you can lock in the shorter investment $100 x 2.5% for two years = $5. So what rate do we need at the end of two years for a three-year term to end up earning the additional $15 to make up the difference? Simple algebra shows that rate would be 5%. That would be the forward implied yield on a three-year term, two years from now.

It is only when the forward implied yield proves to be wrong that there are financial opportunities or pitfalls in the market. If, in our example, the rates on three-year investments really are 5% two years from now, it wouldn’t matter over the long-term which investment we picked today. If rates at the end of the short-term investment are above 5%, the two-year was the better investment pick. If below 5%, the five-year was the better pick.

So, stop dismissing the forward implied yields as inherently wrong and start measuring your assessment of direction and magnitude of future interest rates against the one measure that will clearly display investment decisions that enhance or reduce long-term value, which is the forward implied yield. For a visual presentation of this, you can use this link to observe the historical FHLB Des Moines three-year advance rates alongside the forward implied yields at various interesting points in time since January 2000.

Base Case Scenario

For portfolio interest rate risk management, bankers should consistently be using the forward implied yields for a base case scenario in earnings-at-risk and economic-valuation-of-equity analysis. Given that the forward implied yields represent the points of indifference regarding investment and funding decisions of currently priced transactions, scenarios analyzing rising interest rates should not be merely higher rates than today – they should be rates above the forward implied yields while the lower rate scenarios should be using rates below the forward implied yields.

Testing +400 basis points rate shocks because interest rates are currently low seems arbitrary. Why not consistently test +/- XXX basis points compared to the forward implied yields? You and your regulators can simultaneously respect current market conditions and consistency in your interpretation of the aggressiveness of the proposed shock. In other words, I suggest that a shock of +200 bp against the forward implied yield is a more consistent measure of volatility even if the numbers that result are +200 bp compared to today when we are in a flat rate environment and +400 bp in an upward sloping current yield environment.

Testing the declining interest rate scenario with a currently upward sloping yield curve may, in fact, result in rates close to where they are today. Mathematically, this would be considered a flat rate. However, from a market expectation perspective, it would actually be a lower than the expected level of rates. In this way, we can understand that interest rates may not have to actually decline to be lower than anticipated.

Whether you are looking at individual transactions or entire portfolios, the incorporation of forward implied yields gives you the ability to accurately assess the risks and return opportunities of your positions. In the end, using the forward implied yield is the only way you can really know the score.

Finally, you will benefit greatly if you share this approach with a very important stakeholder – your customers. My client bankers build great trust and professional status with clients when they share the calculation of how much rates would have to go up over the life of the short-term option in order to end up with the same results as the long-term option. You will build relationships and exceed expectations when you not only know the score, but help your co-workers and customers know the score as well.

Mr. Stanley is president of Bank Performance Strategies, an Omaha, Neb.-based consulting firm offering a web-based retail deposit pricing and sales platform. Mr. Stanley also serves as retained counsel for banking strategies at WebEquity Solutions. He can be reached at [email protected].