How good is the bond market at forecasting the risk-free rate?

Open Access

Abstract

The aim of this paper is to determine if the implied forward rates derived from the bond market are a good indicator of the future risk-free rate and understand why discrepancies between these two variables may occur. The fundamental principles of finance will be reviewed in order to explain how time and risk affect the value of money. Then, it will be shown why government' securities are often used as risk-free assets, and therefore, their rate of return is used as the risk-free rate of return in most of the valuation methods. Finally, a quantitative analysis will be performed using data from the U.S. Board of Governors of the Federal Reserve System and Survey of Professional Forecasters. It will find that the accuracy of implied forward rates depends on the length of the forecast and the type of bond. Therefore, taking that into account combined with the fact that implied forward rates data can be easily accessed, this paper concluded that implied forward rates can be used as a reliable indicator of the future risk-free rate if time and resources are a constraint.