Home > CFA L2, fixed income > Interest Rates in the future

Interest Rates in the future

Ever wonder what interest rates will be in the future? If you have a mortgage, you probably have the typical 5-year (or shorter) term. At the end of your term, you have to renew your mortgage for the remaining balance at the then prevailing mortgage rates.

So how can you tell today what rates will be at the end of your mortgage term? The answer is Forward Rates, which are rates implied by current interest rates on various maturity/term bonds.

I have charted the path of 5-year bond yields on the current day (also called Spot Rate) and 2 & 5 years from current day (also called Forward Rates). In other words, the 5 year interest rate, 2 years from now and the 5 year interest rate, 5 years from now.

It is very easy to calculate forward rates and the theory is rather simple, lets calculate the 5-year rate, 2 years from today.

The formula is:

F5 = ((1+S7)^7)/((1+S2)^2)^(1/5) -1

F5 is the 5-year forward rate 2 years from today

S7 is the current 7-year spot rate (5 years 2 years from today = 7 years from today)

S2 is the current 2-year spot rate

Source: Bank of Canada

The 5-year rate, 2 years from now (red line) has been steadily trending down and is around 3.00% now which is higher than today’s 5-year rate of about 2.00%. The down trend is due to yield curve flattening or becoming less steep. I commented on this earlier today.

In other words, 5-year bond yields will increase by 1.00% in the next 2 years.

Word of Caution: Forward rates change continuously with bond yields and hence are not guaranteed future rates for any day other than current day.

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  1. October 6, 2010 at 11:38 PM | #1

    We should expect longer term securities to carry a risk premium. I don’t know what the risk spread would be but that would push down F5 by some level.

    I don’t know what your interpretation is but this tells me the economic recovery is predicted to be much more sluggish than it was 6 months ago.

    • October 7, 2010 at 6:34 AM | #2

      Precisely… that is also apparent from the yield curve.

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