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FEDERAL RESERVE BANK OF ST. LOUIS MARCH 1987 Predicting Interest Rates: A Comparison of Professional and Market-Based Forecasts

By Michael Belongia

Abstract

nterest rates have varied substantially in recent years. Since 1981, for example, the monthly average three-month Treasury bill rate has ranged between 5.18 percent and 16.30 percent while the Baa corporatebond rate ranged between 9.61 percent and 17.18 percent; the prime rate during this time reached a high of 20.5 percent and fell to a low of 7.5 percent. Interest rate movements are important, of course, because they affect the present value of streams of future payments, that is, wealth. Moreover, the risk of interest rate changes is related directly to the level of interest rates. ’ During the l980s, therefore, firms and individuals have faced substantial exposure to interest rate risk. There are at least two approaches that can be taken to reduce the magnitude ofthis problem. The first is to hedge interest rate risk, which has been discussed at length in this Reviewand elsewhere. ’ The second is to forecast the likely course of interest rates. This article investigates the reliability of such forecasts in general and assesses the specific usefulness of forecasts by professional economists. Michael T. Be/ongia is a senior economist at the Federal Reserve Bank of St Louis. Paul Crosby providedresearch assistance. ‘Interest rate risk, for a firm whose portfolio is composed of streams of future receipts and payments, is measured by the interest elasticity of the portfolio; for a single asset, this can be expressed as —nO! 1 + i), where n is the term to maturity. A more general expression for a portfolio of assets and liabilities is derived in Belongia and Santoni (1987). In either case, the level of interest rate risk rises with the interest rate

Year: 2011
OAI identifier: oai:CiteSeerX.psu:10.1.1.198.2962
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