An Adjusted Forward Curve for Spot Rate Forecasting

22 Pages Posted: 21 Jun 2019 Last revised: 5 Oct 2020

See all articles by Camilo Sarmiento

Camilo Sarmiento

Inter-American Development Bank (IDB)

Date Written: June 2, 2019

Abstract

In this paper, we provide adjustments for liquidity and credit risk to the forward Libor rate in order to improve accuracy of the forward rate in forecasting the 3-month Libor rate. In particular, we introduce the adjusted forward curve (AFC) that models the update in the forward curve from one period to the next. A direct modeling of the dynamic process of the forward curve facilitates the specification of adjustment factors to the forward curve, and it underscores the role of mean reversion (stationarity) in the nexus between the forward rate and the future spot rate, The AFC factors that underpin the forward curve bias are statistically relevant with p-values that are less than .00001. The upward bias in the forward curve (i.e., when the forward curve exceeds the expected future spot rate) positively correlates with the steepness of the yield curve in the AFC model. A downward bias positively correlates with the credit spread and industrial capacity utilization. Furthermore, the effect of the instantaneous forward curve on the future spot rate tempers off with time. The predictive power of the AFC model, however, hinges on the forecastability of the underlying factors. The testing indicates that all the AFC model factors have a mean reversion component. Overall, our model effectively anticipates movements in the forward curve that tend to yield a better forecast of the future spot rate.

Keywords: Adjusted Forward Curve, Forecasting Spot Rate, Yield Curve Steepness, Credit Risk, Mean Reversion

JEL Classification: C52, C53, G12, G13

Suggested Citation

Sarmiento, Camilo, An Adjusted Forward Curve for Spot Rate Forecasting (June 2, 2019). Available at SSRN: https://ssrn.com/abstract=3398038 or http://dx.doi.org/10.2139/ssrn.3398038

Camilo Sarmiento (Contact Author)

Inter-American Development Bank (IDB) ( email )

1300 New York Avenue NW
Washington, DC 20577
United States

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