Japan, Goldilocks and Reflation? "Analysis of the Low Interest Rate Environment, and Hedging Strategies for Bond Investors”

Sindre M. Myhre & Anders Bjørnsen

Student thesis: Master thesis

Abstract

This thesis aims to investigate whether the low interest rates seen today could be justified by economic factors, and how we could progress towards our estimated equilibrium. By these assessments, institutional investors sensitivity towards rising rates will be analyzed, to find out whether it is necessary to hedge portfolio exposure.
To assess the possibility of rising interest rates, today’s ”fair” level is analyzed for short and long-term rates separately. Secular stagnation has lowered the natural rate, thus justifying the low short-term rate. Due to unnatural demand factors, causing interest rates to decline, we argue that long-term yields are deviating from their fundamental value.
When analyzing investors interest rate sensitivity, we estimated yield curves based on the Vasicek model, combined with our interpretation of the economic outlook. Further, we divide into three scenarios; Reflation, Goldilocks and Japan style, to cover a broad specter of the future development. We argue the most likely scenario involves a slow progression towards the desired long-term rates (Goldilocks). However, a faster progression seems possible (Reflation), while a permanent low-rate environment seems most unlikely (Japan).
Using two different methods; initial price decline and holding period return, we find the sensitivity for a typical institutional investor to be substantial. We therefore recommend investors to lower their duration through hedging. This is found to be most effectively done on the long end of the yield curve.

Educations, (Graduate Programme) Final Thesis
LanguageEnglish
Publication date2017
Number of pages127
SupervisorsSøren Plesner