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A FRAMEWORK FOR PROJECTING INTEREST RATE SPREADS AND VOLATILITIES
 
 
January 2000
 
 
NOTES

The figures in this memorandum indicate periods of recession by using shaded vertical bars. The bars extend from the peak to the trough of the recession.

Numbers in the text and tables may not add up to totals because of rounding.
 
 
PREFACE

Several recent bills before the Congress have proposed changing the benchmark used in setting interest rates for the federal student-loan program. Lenders participating in the program have urged the change to tie the rates they must pay to borrow funds in private-sector markets more closely to their returns on loans. The Higher Education Amendments of 1998 directed the Congressional Budget Office (CBO) and other organizations to study the issue and, in particular, to evaluate the spreads, or differences, between rates on three-month Treasury bills (the benchmark at that time) and the proposed alternatives, which include rates on commercial paper issued by financial companies and London interbank dollar deposits.

The study group that was formed asked CBO to develop a framework for projecting the future behavior of the alternative rates and the probability that they would exceed the interest rate threshold of the student-loan program. CBO prepared a technical paper in response to the request and presented its model at a study group meeting in August 1999. Since passage of the 1998 bill, the Congress has enacted a temporary change in the benchmark (in December 1999) to use rates on three-month commercial paper as the reference rate for student loans until 2003. CBO's projections will contribute to the debate about whether to make that change permanent.

This memorandum discusses CBO's model and presents illustrative projections of interest rate spreads and their volatilities, or movements, over the medium term (to 2009). Robert Arnold, Angelo Mascaro, and Matthew Salomon of CBO's Macroeconomic Analysis Division wrote the memorandum under the supervision of Robert Dennis and Kim Kowalewski. Nabeel Alsalam, Paul Cullinan, Deborah Kalcevic, Robin Seiler, Bruce Vavrichek, and Thomas Woodward, all of CBO, made valuable contributions at various stages of the analysis. The memorandum incorporates comments from members of the study group and other readers of the technical paper. In addition, the authors thank John Cunningham of Lehman Brothers Inc., Anthony Dolanski and Guido Van der Ven of the Student Loan Marketing Association, Randall Mariger of PricewaterhouseCoopers, and Calvin Schnure and Christopher Downing of the Board of Governors of the Federal Reserve for their useful suggestions.

David Arnold and Ezra Finkin provided research assistance. Leah Mazade edited the manuscript, and Chris Spoor proofread it. Verlinda Lewis Harris and Dorothy Kornegay prepared the memorandum for publication. Laurie Brown prepared the electronic versions for CBO's World Wide Web site (www.cbo.gov).

Questions about the memorandum may be directed to the Macroeconomic Analysis Division.
 

Dan L. Crippen
Director
January 2000
 
 

CONTENTS
 

I - SUMMARY AND INTRODUCTION

II - BACKGROUND ON INTEREST RATES FOR SHORT-TERM FINANCIAL INSTRUMENTS

III - PROJECTING INTEREST RATE SPREADS

IV - PROJECTING INTEREST RATE VOLATILITIES

APPENDIX - Estimating Methods and Econometric Detail
 
TABLES
 
1.  Outstanding Dollar Volume in Markets for Short-Term Financial Instruments
2.  Distribution of Commercial Paper Issuers
3.  Distribution of Commercial Paper Holders
4.  Banks Supplying Interest Rates That Were Used to Construct LIBOR in 1999
5.  Average Interest Rate Spreads for Commercial Paper and London Interbank Dollar Deposits
6.  Volatility and Average Size of Interest Rate Spreads for Commercial Paper and London Interbank Dollar Deposits
7.  CBO's Weighting of Data Periods to Adjust for Changes in the Volatility of Interest Rate Spreads for Commercial Paper and London Interbank Dollar Deposits
8.  Average Interest Rate Spreads Between Rates on London Interbank Dollar Deposits and Eurodollar Deposits
9.  Illustrative Projections of Spreads and Interest Rates for Short-Term Financial Instruments Using CBO's January 1999 Economic Assumptions
10.  Average Levels of Determining Factors Used in CBO's Model for Projecting Interest Rate Spreads
11.  Illustrative Probabilities for Interest Rates on Short-Term Financial Instruments
A-1.  CBO Estimates of Interest Rate Spreads Using Ordinary Least Squares
A-2.  CBO Estimates of Squared Residuals Using the ARCH Model
A-3.  CBO Estimates of Interest Rate Spreads Using Generalized Least Squares
 
FIGURES
 
1.  Interest Rate Spreads for One-Month and Three-Month Commercial Paper
2.  Interest Rate Spreads for One-Month London Interbank Dollar Deposits and One-Month Commercial Paper
3.  Interest Rate Spreads for Three-Month London Interbank Dollar Deposits and Three-Month Commercial Paper
4.  Interest Rate Spreads for Federal Funds, One-Month London Interbank Dollar Deposits, and One-Month Commercial Paper
5.  Interest Rate Spreads Between One-Month and Three-Month London Interbank Dollar Deposits and One-Month and Three-Month Commercial Paper
6.  Volatility of Interest Rate Spreads for One-Month London Interbank Dollar Deposits and One-Month Commercial Paper
7.  Inflation and the Volatility of Interest Rate Spreads for One-Month London Interbank Dollar Deposits
8.  Actual and Projected Interest Rate Spreads for One-Month Commercial Paper
9.  Actual and Projected Interest Rate Spreads for Three-Month Commercial Paper
10.  Actual and Projected Interest Rate Spreads for One-Month London Interbank Dollar Deposits
11.  Actual and Projected Interest Rate Spreads for Three-Month London Interbank Dollar Deposits
12.  Actual and Projected Interest Rate Spreads for One-Month Eurodollar Deposits
13.  Actual and Projected Interest Rate Spreads for Three-Month Eurodollar Deposits
A-1.  Data Weights Used in CBO's Model for Projecting Interest Rate Spreads for One-Month and Three-Month Commercial Paper
A-2.  Data Weights Used in CBO's Model for Projecting Interest Rate Spreads for One-Month and Three-Month London Interbank Dollar Deposits

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