May 15 2008
Trading the Forward Rate Bias
Fidelio Tata, Ph.D.
Head of IR Derivatives Strategy
+1 (203) 618-2116
fidelio.tata@rbsgc.com
Trading the
Forward Rate Bias
The so-called Unbiased Expectations Hypothesis (UEH) suggests
that de-convexity-adjusted forward rates are unbiased predictors
of future spot rates. A well-known phenomenon in the front end of
the yield curve, however, is a systematic bias in forward rates: On
average, forward rates over-estimate future spot rates. While
academic research does not offer a conclusive explanation of the
forward rate bias puzzle, some of the recent work may be worth
reviewing.
The current slope of the money market curve, now implying some
25bp of Fed tightening until year-end, is at odds with what many
(maybe even the majority of) market participants expect. Some of
this disconnect is now attributed to the systematic bias in forward
rates. We discuss some basic trading strategies.
Predictive Power of Fwd Rates
The so-called Unbiased Expectations Hypothesis (UEH) suggests that
de-convexity-adjusted forward rates are unbiased predictors of future
spot rates. A well-known phenomenon in the front end of the yield
curve, however, is a systematic bias in forward rates: On average,
forward rates over-estimate future spot rates. Besides the inherent
bias, the predictive power of forward rates is scarce.
To illustrate the limited informational content of (convexity-adjusted)
forward rates, we consider the following naïve forecasting model:
Spott+1 = α + Fwdt + εt (1)
Fwdt represents the 1-year swap rate, 1-year forward, at time t, while
Spott+1 stands for the subsequently realized 1-year swap rate, 1 year
later. A regression of daily data going back 10 years yields the
following results:
α = -80bp; R-square = 17.3%
Notice that, on average, 1-year-into-1-year forward rates overestimate
subsequent 1-year spot rates by as much as 80bp! At the same time
one needs to admit that the coefficient of determination (R-square) is
The Royal Bank of Scotland

very, very low. This suggests that the statistical model (1) explains only
very little of the variability in the data set.

Trading the Forward Rate Bias | May 15 2008

Forward rate bias Chart 1 illustrates the forward rate bias for 1-year-into-1-year swap
rates. Forward rates, more often than not, are higher than the
subsequently realized spot rates (on average 80bp for the past 10
years).

Chart 1: Systematic bias in forward rates

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% 2
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1y1y fwd minus subsequent 1y spot rate Average fwd minus spot
Fed Funds Target Rate

Source: RBS Global Banking & Markets

Spot rate bias An interesting question is whether spot rates make for a better
predictor of the future. To evaluate the forecasting accuracy of spot
rates, we consider the following model:

Spott+1 = α + Spott + εt (2)

Spott represents the 1-year swap rate at time t, while Spott+1 stands for
the same 1-year swap rate, 1 year later. A regression of daily data
going back 10 years yields the following results:

α = -13bp; R-square = 15.8%

What is striking is that the goodness of fit is even lower than with
forward rates (R-square of 15.8% vs. 17.3%), making spot an even
worse predictor of the future. The fact that spot rates also overestimate
future realized rates (although to a much smaller degree) indicates that
the time series chosen here (past 10 years) captures a drift lower in
yield (1-year swaps from 5.9% on 5/14/98 to 3.65% on 5/14/08). This
also affects the forward rate analysis (equation 1) and ideally one
should choose a period without such trend.

Combining spot and forward Often, practitioners expect realized rates in the future to come in
somewhere between spot and forward. To test this assumption, we
consider the following model:

Spott+1 = α + β Spott + (1-β) Fwdt + εt (3)

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The Royal Bank of Scotland

A regression of daily data going back 10 years yields the following

results:

Trading the Forward Rate Bias | May 15 2008

α = -47bp; β = 47%; R-square = 20.4%

While still not particularly high, the goodness of fit is higher than with
either spot or forward rates alone (R-square of 20.4% vs. 15.8% and
17.3%, respectively). The beta of 47% suggests that roughly the
average of spot and forward makes for the best predictor of the future.

Empirical evidence The results presented here appear consistent with the majority of
studies conducted in academic research. For example, Fama and Bliss
(1987) concluded that, over 1964-1985, 1-year forward rates on
Treasury bills contained information on expected returns on bills one
year in advance.1 When looking at the incremental informational value
of forward rates, studies suggest that forward rates produce better
one-step-ahead forecasts, as well as better once-and-for-all forecasts
of interest rates over a full year horizon than those obtained form the
own past of interest rates.2

While few, if any, studies suggest that forward rates are good
predictors of the future, there is widespread acknowledgement of some
informational value beyond what can be extracted from a history of
spot rates. However, there is also a “bias,” often vaguely attributed to a
term-risk premium, which greatly reduces the value of forward rates as
a signal.

Disconnect between
expectations and forwards
The current market environment suggests that there is somewhat of a
disconnect between what market participants would verbally express
in terms of rate expectations and what is implicitly priced into the
money market curve. This is maybe most obvious when looking at the
Fed fund target rate at year-end. A survey of 54 Street economists
conducted by Bloomberg between May 2 and May 8 resulted in an
average target rate of 1.94% (median of 2%). In other words, there
appears no widespread expectation of a Fed rate hike between now
and year-end. Fed fund futures contracts, on the other hand, implied a
roughly 30% chance of a 25bp hike during the survey period (since
then, this has increased to as high as 100%).

Main theme of 2008 Already for several months, market participants, for the most part, have
been skeptical about the Fed hiking implied for later this year and in
2009, given the fragile economy, the liquidity crisis in the financial
industry and the weak housing market. Year-to-date, it has been a
recurring market theme among many market strategists (including our

1
Fama, E., and Bliss, R., 1987, The information in long maturity forward rates, American Economic Review, 77, 680-692.
2
Dominguez, Emilio & Novales, Alfonso, 2002, Can Forward Rates Be Used to Improve Interest Rate Forecasts?, Applied Financial
Economics, Taylor and Francis Journals, Vol. 12(7), pages 493-504, July 2002.

3
The Royal Bank of Scotland

own) to (explicitly or implicitly) suggest variations of the Forward Rate

Bias trade.

Trading the Forward Rate Bias | May 15 2008

Despite the potential of a prolonged recession, the Eurodollar curve
continues to price for 2-3 25bp Fed tightening moves over a 1-year
period starting in 8-month’s time.3 The steepness in the front end of the
yield curve is nothing unusual: Between January 2001 and June 2004,
a 3½-year period during which no Fed tightening had occurred,
forward rates were implying anywhere between two to eight 25bp
tightenings over a 12-month period. What is implied right now roughly
corresponds to what was priced in for in March 2001. From that point
on, forward rates got it wrong for almost 3 years (see chart 2).

Chart 2: Fed tightening implied for 1yr period starting 8 months forward

Fed starts tightening

Fed starts easing

Fed starts easing

200
175
150
ED5-ED8 spread [bps]

125
100
75
50
25 Forward getting it wrong
0
-25
Jan-00
Jul-00
Jan-01
Jul-01
Jan-02
Jul-02
Jan-03
Jul-03
Jan-04
Jul-04
Jan-05
Jul-05
Jan-06
Jul-06
Jan-07
Jul-07
Jan-08
Source: RBS Global Banking & Markets

Forward Rate Bias trades

A number of generic trading strategies are based, at least to some
degree, on exploring the forward rate bias. Often, those trades are part
of a longer-term trading program. In other cases, investors only enter
into them if their specific view about future rates conflicts with what
forwards are implying. We summarize and discuss the main variation of
those trades below.

1. Buying Eurodollar/Fed fund future contracts

Investors who believe that there is a systematic bias in short-dated
forward rates are known to be active participants in Eurodollar and Fed
fund futures trading. By choosing which contract to buy and by setting
the frequency of rolling the contract, investors can pick the part of the
yield curve that is believed to reflect the highest bias.

3
We highlighted this before in our 2/1/08 edition of U.S. Derivatives Strategy Weekly.

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The Royal Bank of Scotland

Chart 3 displays the cumulative P/L of being long one Eurodollar

futures contract and rolling it every quarter (to keep it at constant
maturity). Over a 10-year period, this strategy would have been

Trading the Forward Rate Bias | May 15 2008

profitable, although part of the calculated gains are just due to the fact
that short-dated interest rates dropped some 200-300bp since 1998 (to
adjust for this, one would have to subtract some $5,000-$7,500 from
the terminal cumulative P/L).

Chart 3: Cumulative P/L of rolling one Eurodollar futures contract

$25,000
$20,000
$15,000
$10,000
P/L
$5,000
$0
-$5,000
-$10,000
Dec-98
Mar-99
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Mar-00
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Jun-06
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Mar-08
ED1 to Exp ED2 to ED1 ED3 to ED2 ED4 to ED3
ED5 to ED4 ED6 to ED5 ED7 to ED6 ED8 to ED7

Source: RBS Global Banking & Markets

According to the analysis presented in chart 3, “Red” Eurodollar packs

(roughly representing the 1-year swap rate, 1 year forward) exhibited
the highest forward rate bias and, thus, are good candidates to a
potential trading program.

2. Curve steepener trades

Because short-dated rates (primarily the ones reflected by Red
Eurodollar pack) appear to be plagued by a forward rate bias to a
larger degree than long-dated rates, forward curve slopes tend to
overestimate the degree of expected curve flattening. This is illustrated
in chart 4, where the spot 2s10s swap slope is compared to what the 1-
year forward-starting 2s10s slope had implied a year before. Notice
that forward rates have been de-convexity adjusted to eliminate the
convexity bias of (especially) longer-dated forward rates.4

4
On the de-convexity adjustment of forward rates, see Gupta, Anurag & Subrahmanyam, Marti G., 2000, An empirical examination
of the convexity bias in the pricing of interest rate swaps, Journal of Financial Economics, Elsevier, vol. 55(2), pages 239-279,
February 2000.

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The Royal Bank of Scotland

Chart 4: Systematic bias in forward slope

Trading the Forward Rate Bias | May 15 2008

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%
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Jun-99
Dec-99
Jun-00
Dec-00
Jun-01
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Jun-02
Dec-02
Jun-03
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Jun-05
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Jun-06
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Jun-07
Dec-07
Jun-08
2s10s spot slope minus de-conv.adj. fwd from a year before
Average spot minus forward slope
Fed Funds Target Rate
Source: RBS Global Banking & Markets

During the past 10 years, the average bias of forward slope

overestimating the degree of flattening to come was about 30-35bp as
far as 2s10s slope, 1 year forward, is concerned. Because curve slope
positions are typically less volatile than outright interest rate exposure,
this expected compensation due to the forward bias is still attractive
from a risk-return perspective. The Sharpe ratio of the structure
displayed in chart 4 is 0.42, close to the 0.47 Sharpe ratio of the
outright 1-year-into-1-year trade displayed in chart 1.5

While evidence of a forward slope bias, in the eyes of many market

participants, may not be convincing enough for entering in a rolling
curve-steepener position as an ongoing trading program, the bias
helps making curve steepening trades look more attractive during
times when investors are looking for curve steepening anyway (such as
during periods of Fed easing).

3. Receiver swaptions
A variation of an outright long position in Eurodollars is to structure the
trade conditionally through Eurodollar and Treasury future (and, to a
lesser extent, Fed fund future) calls, call spreads and call flies.
Similarly (and somewhat easier to analyze from an analytical point of
view), receiver swaptions can be utilized. In any case, the goal is to
explore the fact that strike levels for the options are biased to the
upside, due to the bias in forward rates.

Typically, an analysis into the attractiveness of receiver swaptions

centers around how much roll-down from forward to spot is necessary
to offset the costs of buying the option. Chart 5 illustrates this by
looking at 1-year-into-1-year receiver swaptions. Displayed is the ratio
between the expected value of the receiver swaption at expiration
assuming unchanged spot rates and the premium paid at trade

5
The Sharpe ratio measures the expected return per unit of risk. The risk is measured as the standard deviation of the P/L.

6
The Royal Bank of Scotland

inception. A ratio of 1 suggests that forward rates need to converge to

spot rates (i.e., complete roll-down on the yield curve) to offset the
costs of the receiver swaption. A ratio of 2 implies that, because the

Trading the Forward Rate Bias | May 15 2008

expected roll-down results in a gain twice as large as the upfront
premium, a 50% convergence of forward to spot rates is sufficient for
the trade to break even. As we have shown above (formula 3),
historical evidence suggests that a rate halfway between spot and
forward makes for the best predictor of future realized rates. Thus, any
ratio above 2 looks attractive from a forward rate bias perspective.

Chart 5: Payout Ratio of 1-year-into-1-year receiver swaption

1-year roll-down divided by upfront premium paid

2
Multiple

-1

-2
2000 2001 2002 2003 2004 2005 2006 2007 2008

Source: RBS Global Banking & Markets

The attractiveness of receiver swaptions (and other conditional

variations of forward rate bias trades) highly depends on the general
level of implied volatility. Therefore, those trades are typically favored
whenever the yield curve is steep and implied volatility is low.6

Because the payout ratio has the expected return in the numerator and
a risk measure (swaption price, which is a function of implied swaption
volatility) in the denominator, the fraction is essentially a Sharpe Ratio.
Thus, the attractiveness of receiver swaption trades based on this
payout ratio is inherently measured on a risk-adjusted basis.

Conditional curve trades The same way outright interest rate positions can be structured
bullishly through calls/receivers, curve steepeners can be expressed
conditionally as bull steepener trades. The analysis is similar, only that
the ratio between implied volatilities, not their outright level, is the
second essential driver of the trade (besides the forward rate bias).
Conditional curve steepeners, as a consequence, are often favored
when implied volatility is trading at elevated levels.

6
Unfortunately, this is not often the case, as slope and vol are highly correlated with each other. There is little causation, though
(“correlation does not imply causation”). Rather, both are a function of general uncertainty.

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The Royal Bank of Scotland

4. Receiver spreads
In a receiver spread, the purchase of an at-the-money-forward (ATMF)

Trading the Forward Rate Bias | May 15 2008

receiver swaption is subsidized by selling out-of-the-money (OTM)
receivers. Strike levels and notional weights differ on this kind of
structure, but one of the most popular variations is the premium-neutral
“1-by-2” receiver spread. Here, the notional amount of the OTM
receiver sold is twice that of the ATMF receiver bought, struck at a level
that makes the package premium-neutral.

Like in the outright receiver swaption, the structure profits from a

potential forward rates bias, only that the investor sees limited potential
of interest rates falling below the strike of the OTM receiver.

Receiver spreads have more leverage than simple receiver swaptions

(due to the fact that the initial upfront premium is reduced, or even
zero), but add downside risk to the trade. Also, the analysis of receiver
spreads typically incorporates volatility skew (i.e., the difference
between implied ATM and OTM swaptions).

Break-even rate Often, the attractiveness of receiver spreads is measured against the
break-even rate. This rate shows how much rates can drop before the
structure starts losing money (at swaption expiration) and can be
compared to what economic analyses suggest the likelihood of such a
rally would be.

Table 1 shows the break-even rates of various 1-by-2 receiver spreads

as of April 11, 2008.

Table 1: Break-even rates for 1-by-2 receiver spreads

↓Expiry Tail→ 1y 2y 3y 4y 5y 7y 10y 30y

1m 2.07% 2.09% 2.42% 2.72% 2.97% 3.31% 3.82% 4.33%

2m 1.98% 2.07% 2.42% 2.53% 2.78% 3.30% 3.61% 4.08%
3m 1.86% 2.00% 2.17% 2.48% 2.73% 3.05% 3.55% 4.00%
4m 1.75% 1.92% 2.30% 2.41% 2.67% 2.98% 3.46% 4.10%
5m 1.64% 1.84% 2.23% 2.34% 2.59% 3.09% 3.37% 3.98%
6m 1.53% 1.76% 2.14% 2.45% 2.70% 3.00% 3.27% 3.85%
7m 1.63% 1.87% 2.05% 2.36% 2.60% 2.89% 3.36% 3.91%
8m 1.53% 1.78% 2.16% 2.46% 2.50% 2.98% 3.24% 3.77%
9m 1.63% 1.89% 2.06% 2.36% 2.58% 2.86% 3.31% 3.83%
10m 1.53% 1.79% 2.16% 2.45% 2.47% 2.94% 3.19% 3.68%
11m 1.43% 1.89% 2.05% 2.33% 2.55% 2.82% 3.25% 3.72%
1y 1.55% 1.81% 2.16% 2.43% 2.64% 2.90% 3.13% 3.77%

Source: RBS Global Banking & Markets, as of 4/11/2008

Receiver butterfly A three-legged receiver spread is a receiver butterfly. Here, the

maximum downside of the two-legged 1-by-2 spread is reduced by
buying back an even further-OTM receiver. Naturally, this is no longer
premium-neutral and an analysis of this structure not only depends on
volatility skew, but also on some sort of comparison between expected
payout and premium paid.
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The Royal Bank of Scotland

Trading the Forward Rate Bias | May 15 2008

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