Forecasting Variable Rate Cash Flows

Overview


Variable rate fixed income assets pay a pre-specified interest rate that resets periodically, taking the value of whatever the current market rate is at every reset date. Because future rates are unknown, it is impossible to calculate the cash flows with any degree of certainty.

There are two strategies for forecasting variable rate cash flows.

  • Forecast Based - create a forecast of how interest rates evolve over the future and take the forecasted values as the cash flow forecasts. In particular, the current shape of the curve can be used to create a forecast. (see term structure theories)
  • Monte Carlo - run monte carlo simulations forecasting the cash flows in a large number of scenaris

Forecast Based Implementation


The following code implements a simple forecast of a variable rate asset. It assumes that there is a function which returns the current forward short rate on the interest rate curve for the inputted date. (see fixed income curves) It also assumes that the reset dates are given in the dates array. For each reset date, it takes the value of the curve at that date as the forecasted value of the variable interest rate. (Note the reset date sets the rate on the instrument, the payment will occur on or around the next date) 


function curve(date){
  //returns the current rate at the given date along the curve
}

let cashFlows = [];
let dates = ['2020-01-01', '2020-04-01', '2020-07-01', '2020-10-01'];
dates.forEach(date=>cashFlows.push(curve(date)))

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