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Basic Interest Rate Anticipation Strategies

There are a variety of interest rate anticipation strategies. Those which involve moving between long-term government bonds and very short-term treasury bills are based on interest rate forecasts and the way values of securities respond to fluctuations in interest rates.

Basic interest rate anticipation strategy involves moving between long-term government bonds and very short-term treasury bills, based on a forecast of interest rates over a certain time horizon, to provide the maximum increase in price for a portfolio.

Given that long-term bonds change the most in value for a given change in interest rates, a manager would want to hold long-term bonds when rates are falling.

The reverse is true in a rising interest rate environment. Long-term bonds fall the most in price for a given rise in interest rates, so a manager would want to hold treasury bills, which have a very short duration and do not change very much in value. These securities have fixed coupons, which means their price is determined by new issues and relative value in the market.

For example, if a new 10-year government bond is issued with a 6% yield, suddenly an existing 10-year government bond yielding 8% looks quite attractive. Given the new issue’s lower yield, investors will buy the higher yielding bond, pushing up its price, lowering its yield. As a result, demand for the bond will taper out as its price rises.

A more sophisticated interest rate anticipation strategy might involve the use of “zero coupon” or “strip” bonds, which are far more sensitive to interest rate changes than normal bonds. Zero coupon bonds have no coupon payments and therefore have a much longer duration. Their high price volatility makes them especially suitable for speculating on interest rate movements. As the saying goes: “When you are right you are very, very, right and when you are bad you are horrible”.

Mangers looking to implement interest rate anticipation strategies at a lower transactions cost will often look at interest rate derivative securities, such as options and futures.

Market traded or “over-the-counter” (OTC) securities are an alternative option to using actual bonds to place “bets” on the future course of interest rates.