Paper No. 17, Nov 1999

MAS Occasional Paper No. 17, Nov 1999

Extracting Market Expectations of Future Interest Rates from the Yield Curve: An Application Using Singapore Interbank and Interest Rate Swap Data

By Financial & Special Studies Division, Economics Department
Monetary Authority of Singapore

Executive Summary


1      Of late, there has been considerable interest in using implied forward interest rates as indicators of financial market expectations of future interest rates. The appeal of the implied forward rate is that it is easier to interpret for monetary policy purposes, and can be used under appropriate assumptions to infer market expectations of the future path of nominal interest rates. In this paper, we estimate the term structure of interest rates in Singapore using interbank interest rates (for shorter maturities) and interest rate swap rates (for longer maturities). The estimated term structure then allows us to extract the implied forward rates at various points in the future. We then formally test the ability of the implied forward rate to forecast the corresponding future spot rate.

2      The term structure of interest rates shows the relationship between the spot rates on a fixed-income instrument and its maturities. At a given trade date, a spot rate curve relates spot rates to its maturities, while a forward rate curve plots forward rates as a function of different settlement dates. While the two curves are alternative ways of representing the term structure of interest rates, the forward curve is frequently more informative since it makes explicit market participants' expectations of future spot rates. According to the pure expectations theory of the term structure of interest rates, the forward rate represents market expectations of the future spot rate, if investors are risk neutral.

3      We fit spot rate curves to the data, and subsequently extract forward curves for one- and three-month rates, for two dates: 15 Jun 98 and 28 Jun 99. On 15 Jun 98, the spot curve was inverted, implying that the market expected short-term interest rates to fall over time. The 3-month implied forward curve, which was below the estimated spot curve, indicated that the market expected the three-month spot rate to fall from 9.4% on that day, to 7.7% in six months time. The position of the spot curve was much lower on 28 Jun 99, as financial markets were relatively normal compared to the crisis period. The estimated spot curve and implied forward curves were upward-sloping, indicating that the market expected interest rates to rise. The implied three-month forward rate was 3.6% in six months time, compared to the three-month spot rate of 2.2% on that date.

4      We also test the power of the three-month forward rate to forecast the spot rate one month, two months and three months from the trade dates. Our results show that the implied forward rates extracted from the spot rate curves provide, on average, an unbiased forecast of future spot rates two and three months ahead. In addition, scatter plots of the implied forward rate against the actual spot rates generally support the test results, although there were several outliers, indicating over-prediction of the actual spot rate by the implied forward rate. These corresponded to data from two sub-periods, namely 22 Dec 97 to 2 Feb 98, and 15 Jun 98 to 13 Jul 98, and are therefore likely to reflect the increased volatility in the financial markets as a result of the Indonesian and Korean crises during the first sub-period, and the Russian crisis during the second.

5      Our analysis shows that the implied forward rate curve, especially at shorter settlement horizons, can be a reliable indicator variable providing policymakers and market participants with information on financial market expectations of monetary conditions in the near future.


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Last Modified on 26/11/2016