An Index for Forward Rates, FRAs in South Africa

This has to do with our discussion of forward interest rates, and forward rate agreements (FRAs), in class last week. Two interesting news items:

Firstly, about a year ago, Standard & Poor’s came out with a number of country-specific forward interest rate arbitrage indices, that:

…model the outcome of a forward interest rate arbitrage strategy that seeks to profit from the commonly observed tendency for forward interest rates to be overstated by the spot yield curve. They consist of indices that represent the G10 currencies for which a liquid futures contract on an applicable three-month interest rate exists. [link]

By “forward interest rate arbitrage strategy,” they are talking about what we called yield curve play in class last week. To make it clearer, they mention in their prospectus:

In most interest rate markets, long-term interest rates tend to be higher than short term-interest rates. Since a long-term rate can be replicated by holding and rolling over a series of short-term rates, this implies that forward short term rates are generally priced at higher yields than equivalent spot short term rates. According to Goldin, “The S&P Forward Interest Rate Index Series model the outcome of a strategy that seeks to profit from the commonly observed tendency for forward interest rates to be overstated by the spot yield curve.”

The S&P index most likely provides a benchmark for the return on these yield curve plays, based on their methodology of calculating forward interest rates. Note that yields vary across countries, so they have indices on seven different currencies, all of which trade interest rate futures. These are the exchange-traded versions of an FRA, and we will be talking about Eurodolllar futures in class, soon (Chapter 6 – if you want to get a head start).

The second news article has to do with FRAs in South Africa as indicators of the spot rates. As you recall, we used the forward rates that are implied by the current zero or spot curve. Also, I mentioned in class that for FRAs, counterparties almost always use forward rates as the agreed-upon rates. We assumed that spot rates stayed the same. What if, however, a change in the spot rates was imminent, and all market participants expected such a change? In this case, the forward rates move away from those predicted by the current zero curve, and move closer to something that better represents what they think zero rates will be in the future. This is what is currently happening in South Africa, where market participants are speculating that rate cuts by the South African central bank are imminent:

Forward-rate agreements showed that contracts for three- month cash due one month from now declined 60 basis points to 6.417 percent, the lowest since at least February 1999. That compares with a three-month Johannesburg interbank agreed rate of 6.61 percent as of 10:59 p.m. local time. [link]

As the article goes on to state:

Analysts are increasing bets that the South African Reserve Bank may lower its benchmark interest rate for an eighth time since December 2008 after a report yesterday showed retail sales unexpectedly contracted for a 13th consecutive month in February. Monetary policy makers led by Governor Gill Marcus made a surprise 50 basis-point cut in South Africa’s benchmark interest rate on March 25 to 6.5 percent, the lowest in at least 12 years.

South Africa’s main interest rate compares with benchmark deposit returns of 0.1 percent in Japan and 0.25 percent in the U.S., making the rand an attractive purchase for so-called carry trades. The transactions, which involve borrowing money in countries with low rates to invest in markets that offer higher returns, have helped the rand rally almost 28 percent since the start of last year.

The motivation for many of these FRAs are carry trades, which take advantage of currency and interest rate differentials between countries. That is a little outside the scope of our class, but the above is an example of the forward rates predicting the spot rates, instead of vice versa (as we studied in class).

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