FORECASTING INTEREST RATES OBJECTIVE: Monitor and forecast interest rates and growth in the economy. In this assignment, you create several interest rate charts that you can update each quarter as the program progresses. They will make forecasting easier and will provide a quick visual reference for the whole team. You use these charts to forecast interest rates; this can help you obtain the least expensive purchased money that might be available. It is also a good idea to compute the inflation rate and growth rate of GDP, the Index of Industrial Production, and Housing starts each quarter. Tracking trends from quarter to quarter in these variables will provide a good indication of the strength or weakness of the economy and therefore, the potential for growth of your bank’s assets, such as loans.
FED FUNDS AND T-BILLS % Rate
| | 15% || | | 10% || | | 5% || | |
| QTR 1.4
| QTR 2.1 T-Bills Fed Funds Borrowing Fed Funds Lending
| QTR 2.2
| QTR 2.3
In this chart, you first compile the information you have in the printout on T-bills and Fed funds rate; you then use this information to forecast future rates. We created the chart using hypothetical economic data. The actual T-bill rates for periods 1.4 and 2.1 appear in the printout at the bottom of page 6 as "Yield." The Fed funds purchased and Fed funds sold rates for each quarter are the averages between the rates "At Start of Qtr" and "At Present," from page 7. For the next quarter, the T-bill rate appears as the 90-day U.S. government rate on page 7 of the printout, but you must forecast the Fed funds rates based on the information you have charted so far. Use the T-bill rate and the Fed funds rate at the start of the quarter to forecast the actual Fed funds rate for the quarter. The relationship between Fed funds and T-bill rates will change but usually only gradually. In other words, T-bills may have a higher or lower interest rate, but they will follow the same trend as Fed funds rates. Because you know the T-bill rate, you can usually project the Fed funds rates based on this relationship.
You need to have an accurate forecast of Fed funds rates for the next two quarters because they are an alternative to purchasing CD's. Of the rates in these two charts, the Fed funds rates are typically more volatile than any of the other rates, but after several quarters, you can usually forecast Fed funds rates very accurately for one quarter and reasonably accurately for the next six months, using your chart. If the spread between Fed funds sold and purchased changes significantly, you can sometimes expect a change in the economy and the direction of interest rates. The greatest spread generally occurs at the peak and trough of interest rate cycles. You can use this information to decide whether to fund your assets with Fed funds purchased or CD's, a decision that might significantly affect your profitability.
PRIME AND MONEY MARKET SAVINGS % Rate | | 15% || | | 10% || | | 5% || | |
| QTR 1.4
| QTR 2.1
| QTR 2.2
| QTR 2.3
Prime Rate Money Market Savings
For the second graph, simply plot the and money market savings rates each quarter. (On page 7 of the printout, use the rate "At Start of Qtr" for the current quarter.) This chart is a good broad-based indicator of the spread between cost and use of funds. You can use the information from the above charts in numerous individual and team assignments, particularly the Forecasting Bank Income and Dividend Policy and Bank Performance & Objectives assignments. On another chart, you should record the changes in the securities yield curves (page 7) from quarter to quarter. The information from this chart will sometimes signal a change in the economy. Used in conjunction with the previous chart, it is a powerful forecasting tool.
YIELD CURVE % Rate | | 15% || | | 10% || | | 5% || | | T-Bill Qtr 2.4 Qtr 2.3 Qtr 2.2
| 180Day
| 1 Yr TIME TO MATURITY
| 5 Yr
| 10 Yr
This graph shows that long-term interest rates have been increasing at a much slower rate than short-term. Investors, therefore, would forecast that long-term rates are stabilizing near a peak and expect them to move downward in the near future. When long-term rates begin to move down, they in turn affect shorterterm rates, pushing them downward. When long-term rates go down more slowly than short-term rates, you can expect that short-term rates are near a high or low point in the cycle. Of course, you should analyze this conclusion within the context of the critical economic indices (i.e., industrial production, GDP, housing starts, net reserves in banks, and so on). If you have enough time, you will also find it useful to graph other variables such as the percentage change in the GNP and CPI levels or your bank's 3-month CD rate against the Fed funds borrowing rate. DO NOT BET THE FUTURE OF YOUR BANK ON THE ECONOMIC FORECAST. Whenever rates are going up or down, you should generally assume those trends will continue. However, as you begin to see signs that a change may occur, exercise caution. If you are correct on the economic forecast, you will produce extra earnings, but if you are wrong, the penalties are usually more severe than the benefit you can derive from being right. When you bet on the economy, you take a big risk. You take little risk if you have the bank in a position in which an unexpected change in the economy will not affect earnings significantly. As you review the graphs each quarter, consider these questions: How would a 100 basis point increase in the CD rate versus a 200 basis point increase in the Fed funds purchased rate affect your bank? How would a 100 basis point increase in commercial loan rates versus a 200 basis point increase in Fed funds sold rate affect your bank? Would a 50 basis point increase in the money market savings account rate increase interest costs by more or less than a 50 basis point increase in the CD and Fed funds purchased rate?
FORECASTING SECURITIES INCOME To complete the with your team, you need to forecast income from securities for the coming quarter. As you calculate this income, keep U.S. securities, which are taxed, separate from munis, which are tax-free. First calculate the income you will lose from securities maturing next quarter. On page 6 of the printout, read across the top line; multiply the par value by the coupon rate and divide by 4 to determine the income for 1-year and 5-year bonds and for munis, series A and B. All T-bills mature and the quarterly interest is reported on page 2 footnote 8. For example, from the period 2.1 printout we can see that in period 2.2, income will be reduced by $.074 million on munis series A [(5 X .059)/4], and $.006 million on munis, series B [(.667 X .034)/4]. Next calculate the income you will lose because of securities you sell. Because you indicate the amount and maturity date on your decision form, you can easily determine the amount of income you will lose using the information on page 6. If you plan to buy securities, determine the amount of income you will gain using the rates on page 7. For example, on the Period 2.2 Sources and Uses statement completed earlier (Pg. 99-102), we decided to purchase $308m in new securities. Let's assume for this example, we purchased $278m in T-Bills, $20m in 1-yr. Notes and $10m in 5 yr. Notes. This would increase income in period 2.2 by $5.718 million [(278 X .0733)/4 + (20 X .0808)/4 + (10 X .0878)/4 = 5.094+.404+.220 = $5.718m ]. Finally, subtract the income from maturities and sales, and add income from purchases to the current quarter's income (footnote 7, Q2.1 statement page 2). So in quarter 2.2 we would have interest of $12.736m from government securities (quarter 2.1 income of 10.61 (T-Bills 3.028 + UST Notes 7.582) plus income from the newlypurchased securities of 5.718 minus maturing interest of 3.631 (T-Bills 3.028 + 1-yr. UST Notes (28 X .0748)/4 =.524 + 5-yr. UST Notes (6 X .0530)/4 =.080 ) and $6.129 from munis (quarter 2.1 income of 6.209 minus maturing interest of .08 (Series A (5 X .059)/4 = .074 and Series B ((.667 X .034)/4 =.006). If the computer model is going to be forced to buy T-bills to meet your bank's pledge requirements, don't forget to calculate the amount of the purchase and the interest income. FORECASTING CD INTEREST EXPENSE You will also need to calculate the interest expense for CD's to complete the bank's with your team. You can readily calculate the interest expense on all the CD's that will remain in your bank's portfolio after maturities by using the data in footnote 10 on page 2 of the printout. Multiply the rate times the amount and divide by four. Record this on the pro forma statement. For example, from the 2.1 printout, we can see that in 2.2, the bank will have interest expense of $1.1 million for 6-month CD's (.0884 X 50/4), plus $2.535 million for one-year CD's from quarter 2.3 (.0845 X 120/4), plus $2.305 million from those maturing in 2.4 (.0878 X 105/4), plus $1.731 million from those maturing in quarter 3.1 (.0923 X 75/4). If you calculate these amounts prior to the team meeting, you will only need to calculate and add in the cost of the new CD's your team decides to purchase. For example, when we forecasted sources and used for quarter 2.2 earlier (Pgs. 99-102), we decided to purchase $690 million in CD's: $390 in 3-month CD's, $300 in 6-month CD's, and $0 in 1-year. The rates for these are found on page 7 of the quarter 2.1 printout. The additional expense comes to $8.073 million for 3-month (.0828 X 390/4) and $6.465 million for 6-month (.0862 X 300/4. Total interest expense for CD's in quarter 2.2 would be $22.21 million (already outstanding CD interest from last paragraph of $7.671m plus newly issued CD interest of $14.54m).
PRO FORMA INCOME STATEMENT (Hypothetical Quarter 2.2) Interest Expense CD's (3-month) (6-month) (1-year) 390.0 50.0 300.0 120.0 105.0 75.0 0.0 X X X X X X X 8.28% / 4 8.82% / 4 8.62% / 4 8.45% / 4 8.78% / 4 9.23% / 4 9.03% / 4 = = = = = = = 8.07 1.10 6.47 2.54 2.30 1.73 0 $22.21m