On Forecasting Interest Rates: An Efficient Markets Perspective

This paper reviews, from an applied forecasting perspective, the properties of short- and long-term interest rates in an efficient market. The paper emphasizes that efficient markets do not preclude economic agents from successfully forecasting movements in short-term interest rates. For brief forecast intervals, however, ex ante changes in long-term rates are sufficiently close to zero that economic agents are not likely to improve upon the no-change prediction of the martingale model. Economic agents, in effect, are not likely to succeed in forecasting short-term movements in long-term interest rates. An analysis of three sets of Canadian interest rate forecasts provides results which are consistent with the theoretical discussion, Further, these results parallel those obtained in recent studies of recorded forecasts in the United States, although the authors of these latter studies apparently failed to appreciate the nature of their findings.

Employee Valuation of Pension Claims and the Impact of Indexing Initiatives

There is discussion in both Canada and the United States of the government's requiring private pension plans to provide contractual cost-of-living protection. This paper employs both an auction and an implicit contract model to identify the compensating wage differentials required of possible indexing initiatives. The contract model, motivated by the prevalence (especially in Canada) of ad hoc cost-of-living adjustments to pensions in pay, presumes that workers have a call option on the investment earnings in excess of the interest rate assumption used to value the plan. The case for policy action would appear to rest on either (1) the assumption that workers misperceive the value (and, possibly, the security) of pension benefits or (2) the presumption that society should subsidize pension income by providing to pension plans an investment vehicle (such as an index bond) whose risk-return characteristics cannot be duplicated by portfolios of existing assets.

Valuing Pensions (Annuities) with Different Types of Inflation Protection in Total Compensation Comparisons

Pensions provided in the public sector are often indexed, while pensions in the private sector typically are not. To conduct the total compensation comparisons that ostensibly guide government pay policy, one must value annuities which differ in their degree of inflation protection. This paper conducts this exercise from the viewpoint of modem finance theory, and contrasts the results with those of a representative government, the Government of Canada. The results suggest that governments may typically understate the value of indexed pensions and overstate the value of pensions which receive incomplete inflation protection. A contributing factor is the apparent belief that standardizing actuarial assumptions is sufficient to ensure comparability, in spite of the fact that risk is ignored and that interest rate and inflation assumptions are typically not those of the market.

Risky Assumptions: A closer Look at the Bearing of Investment Risk in Defined-Benefit Pension Plans

There is reason to question whether employers bear all – and employees none – of the investment risk in defined-benefit pension plans. So are they just defined-contribution plans in disguise?governance and public institutions, pension papers, investment risk

The October 1979 Change in the Monetary Regime: Its Impact on the "Forecastability" of Interest Rates

Subsequent to the October 1979 shift in monetary policy in the United States, interest rates in North America not only reached unprecedented levels,but also exhibited unprecedented volatility. This paper shows that the anticipated quarterly changes in long-term rates associated with the rational expectations model have remained small during this post-shift period. Recorded forecasts of long-term interest rates in Canada continue to prove inferior to the no-change prediction of the martingale model. The "perverse" relationship between the slope of the yield curve and the subsequent movementin long-term rates exists in the Canadian data, but is of only modest value in a forecasting context. The excess return on long-term bonds implicit in the recorded forecasts of the level of interest rates varies sharply, yet there is no evidence that forecasters have identified a predictable component of a time-varying term premium.

Retirement Annuity Design in an Inflationary Climate

This paper examines the tilt and risk-return characteristics of real retirement incomes provided by variable annuities tied to bills, long-term bonds, stocks and a mixed portfolio which combines all three. The analysis emphasizes the riskiness of the real value of benefits provided by conventional nominal annuities. The Rockefeller Foundation Plan, together with the "ad hoc" cost-of-living adjustments made by many large firms, are interpreted as representative market responses to increased inflation uncertainty. The paper examines the annuity designs implicit in these innovations, and shows them to be variants of the standard variable annuity.

The Response of Interest Rates to the Federal Reserve's Weekly Money Announcements: The "Puzzle" of Anticipated Money

Researchers, using the survey conducted by Money Market Services, Inc., have found that the anticipated component in the Federal Reserve's weekly money supply announcement is negatively correlated with the post- announcement change in market yields. We prove that eliminating a (downward) bias in the measure of anticipated money can, in theory, eliminate this puzzle, but that improving the efficiency of an already unbiased measure cannot. We find, using Canadian as well as U.S. interest rate data, that correcting the downward bias in the survey measure reduces, but does not eliminate, the role of anticipated money.