Why Long Term Forward Rates (Almost) Always Slope Downwards

IFA Working Paper No. 299

42 Pages Posted: 27 Mar 2000

See all articles by Stephen M. Schaefer

Stephen M. Schaefer

London Business School - Institute of Finance and Accounting

Roger H. Brown

Warburg Dillon Read

Date Written: February 2000

Abstract

The paper documents a persistent and thus far largely overlooked empirical regularity in the yield curve: the tendency for the term structure of long term forward rates to slope downwards. The persistence of this feature is demonstrated using data on US and UK Government conventional (nominal) bonds and UK Government index-linked bonds. We show that the downward slope is the result of interest rate volatility. Using a two factor Gaussian model we show that the long term forward rate curve will be downward sloping whenever the volatility of the long term zero coupon yield is sufficiently high. Using data on US Treasury STRIPs, the paper further shows that the slope of the forward rate curve predicts the volatility of long term rates and that the implied volatility from bond futures options explains the slope of the forward rate curve.

JEL Classification: G12, G13, E43

Suggested Citation

Schaefer, Stephen M. and Brown, Roger H., Why Long Term Forward Rates (Almost) Always Slope Downwards (February 2000). IFA Working Paper No. 299. Available at SSRN: https://ssrn.com/abstract=213390 or http://dx.doi.org/10.2139/ssrn.213390

Stephen M. Schaefer (Contact Author)

London Business School - Institute of Finance and Accounting ( email )

Sussex Place
Regent's Park
London NW1 4SA
United Kingdom
+44 171 706 6887 (Phone)
+44 171 724 3317 (Fax)

Roger H. Brown

Warburg Dillon Read ( email )

5th Floor
Finsbury Avenue
London EC2M 2PP
United Kingdom

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