Finance Basics, part 2

The second key point and the first corollary to market efficiency is to understand the term structure of interest rates – to understand that interest rates differ according to different maturities, so the interest rate on treasury bills is different from the interest rate on 10-year bonds and the interest rate on 30-year treasuries. So we can look at the term structure of interest rates and work out where the market expects interest rates to go.

We can do this by working out what are called break-even, or forward, rates. For example, suppose the rate on a one-year government bond was 5 percent and that on a two-year bond 6 percent. Since on the two-year bond you will earn 1 percent more than on the one-year bond, to break even the investor has to catch up by reinvesting the proceeds from the one-year bond at a 1 percent higher rate next year, that is, at 7 percent. In this case, earning 5 percent from the one-year bond and then expecting to earn 7 percent from reinvesting in a one year bond next year will earn the same return as investing for 6 percent for two years.

By performing similar break-even calculations for bonds with maturity dates for three, four, five years, and so on, it is possible to calculate the break-even rates for all future time periods. The theorem of unbiased expectations then allows us to use this as the market’s forecast of future interest rates.

I am often asked how you judge the quality of a forecast. The answer is you have to compare it to something, and the obvious answer is to compare it with this market forecast. Suppose, for example, you’re convinced that market interest rates are going up. Does this mean you should invest in one-year bonds at 5 percent and wait for interest rates to go up just as you forecast? The answer is no. As I just showed by calculating the breakeven rate of 7 percent, we have a benchmark to judge the forecast against. If you think interest rates are going up to 8 percent, then invest for one year, and if you are right, you can rollover at this higher rate and be ahead of the return on the two-year bond. On the other hand if you think interest rates are only going up to 6 percent, then buy the two-year bond: Obviously two years at 6 percent is better than a year at 5 percent and then a year at 6 percent.

These break-even rates also allow us to judge how good economic forecasters are. It is not enough to estimate that one- year interest rates will go up from 5 percent to 7 percent; that forecast is free and in every newspaper. A forecaster has to add value by beating this free forecast, which in practice turns out to be very difficult. Once these break-even rates are calculated, the investor can determine whether to buy long- or short-term government bonds and to question whether their views are correct; either way they should listen to the market.