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FINANCE IN ACTION: INTEREST RATE FUTURES CONTRACTS AND
THE 2004 AUSTRALIAN ELECTION1
Steve Easton, University of Newcastle
This case study examines the prices of interest rate futures contracts traded on the Sydney Futures
Exchange before and after the October 2004 election. In this election, the possible effect of the
election outcome on interest rates was a key point of differentiation between the parties. The Prime
Minister, John Howard, and his Liberal–National Party Coalition Government campaigned under
the slogan that re-electing them would ‘Keep interest rates low’. In addition, they ran
advertisements showing the double-digit interest rates that prevailed under Labor Governments in
the 1980s and early 1990s. The Australian Labor Party (ALP) countered by quoting a Reuters
survey of 14 financial market economists, all of whom stated that the party in government would
make no difference to the level of interest rates over the following three years.2
The election outcome and interest rates
There is voluminous evidence to suggest that financial markets are efficient with respect to
processing information and that the assumption of a rapid and unbiased reaction to the arrival of
new information is a realistic one.3 However, no studies have examined the impact of elections on
market variables such as interest rates. Because financial markets are efficient with respect to
processing information, interest rates at any point in time will factor in the probability of the ALP
and Liberal–National Party Coalition being in government, together with expectations of the
impact, if any, of either government on interest rates. 4 On Friday 8 October 2004, there was a
probability that the Coalition would be re-elected and a probability (1 – p) that an ALP government
would be elected. On Monday 11 October, p had increased to 1 and (1 – p) had decreased to 0.
Therefore, any expected impact of either government on interest rates would be reflected in changes
in interest rates between Friday 8 October and Monday 11 October.
Specifically, if p is the probability of the Coalition winning the election, r1 is the interest rate
immediately before the election, r2 is the interest rate immediately after the election of the Coalition,
and r3 is the implied expected interest rate immediately after the election had the ALP been elected,
then:
r1 = pr2 + (1 – p) r3
and
r3 = (r1 – pr2)/(1 - p)
The difference in interest rates between the possible election outcomes is r3 – r2.
1
This case study relies extensively on Easton and Gerlach (2005).
For a discussion of these claims and counter claims, see ‘Interest rates same under either party’, Australian Financial
Review, 25 September 2004, p. 8; ‘Economists reject interest rate claims’, Sydney Morning Herald, 25 September 2004,
p. 14; ‘Howard guilty of scare tactics on rates’, Australian Financial Review, 28 September 2004, p. 57; and ‘Scary
interest rates hit home’, Australian Financial Review, 11 October 2004, p. 10.
3
For a review of the literature, see Fama (1991) and Peirson et al. (2005), Chapter 17.
4
Most elections provide little new information because most election outcomes are largely consistent with expectations
held prior to polling day. Two exceptions would appear to be the October 1980 re-election of the Liberal–National Party
Coalition Government of Malcolm Fraser and the March 1993 re-election of the Labor Government of Paul Keating.
The Fraser re-election was followed by a one-day increase in the All Ordinaries Index of 6.63% (the highest one-day
return on the Australian market over the thirty-year period from 1974 to 2003), while the Keating re-election was
followed by a one-day decrease in the All Ordinaries Index of 2.21%.
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Case studies t/a Business Finance 9e by Peirson et al.
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Two measures are therefore needed to assess the effect of the election outcome on interest rates.
First, we need a measure of the impact of the election outcome on interest rates. Second, we need a
measure of the probability immediately prior to the election of either party winning.
With respect to the impact of the election result on interest rates, we may examine changes in the
interest rate futures prices on the Sydney Futures Exchange between Friday 8 October and Monday
11 October.5 As shown in Table 1, the annual yield on three-year bond futures contracts maturing in
December 2004 fell from 5.32% per annum to 5.24% per annum, while the annual yield on ten-year
bond futures contracts maturing in December 2004 fell from 5.565% per annum to 5.475% per
annum. The yield on 90-day bank bill futures contracts also fell, with the smallest fall being in the
contract maturing in December 2004 (0.02%) and the magnitude of the fall increasing for more
distant contract maturities.
Table 1 Interest rate futures contracts traded on 8 and 11 October 2004
Contract
Time period covered by
contract
8 October
yield (%)
11 October
yield (%)
11 October
yield (%)*
December 2004
10 December 2004–10 March
2005
5.42
5.40
5.49
March 2005
11 March 2005–9 June 2005
5.48
5.43
5.65
June 2005
10 June 2005– 8 September
2005
5.53
5.47
5.73
September 2005
9 September 2005–8
December 2005
5.58
5.52
5.78
December 2005
9 December 2005–9 March
2006
5.62
5.56
5.82
March 2006
10 March 2006–8 June 2006
5.67
5.61
5.87
June 2006
9 June 2006–7 September
2006
5.72
5.65
5.95
Three-year bond
December 2004
15 December 2004–15
December 2007
5.32
5.24
5.59
Ten-year bond
December 2004
15 December 2004–15
December 2114
5.565
5.475
5.865
90-day bank bill
Maturity date
*The data in this table were obtained from Australian Financial Review, 12 October 2004, p. 47. The last column shows estimated
yields had the ALP been elected.
To examine the statistical significance of the 0.08% per annum change in the yield on the December
2004 three-year bond futures contract, we analysed daily yield changes from 31 August 2004 to 15
December 2004 (the period from the beginning of continuous daily trading in the contract to the
expiry of the contract). Of the 77 daily differences, only 4 (5.2%) were –0.08% or lower. Fitting a
normal distribution to these 77 observations yields a probability of obtaining a daily change in yield
as low as –0.08% of 0.049. Using the standard non-parametric density estimate in the statistical
software Splus, and numerically integrating, gives this estimated probability as 0.050.
Consistent with the work of Wolfers and Leigh (2002), the probability of the Coalition being reelected may be inferred from the odds offered by bookmakers.6 On Friday 8 October, Centrebet was
offering $1.20 for a $1 bet on a Coalition win, and $4 for an ALP win, indicating that the betting
market was placing a 77% probability on a Coalition win. These odds and this implied probability
were stable in the days preceding the election. However, on the morning of the election the odds
5
More sophisticated modelling of interest rates was also untaken in addition to the simple no-change expectations
model reported here. However, alternative models such as those incorporating international interest rate movements and
conditional volatility processes gave equivalent results.
6
Wolfers and Zitzewitz (2004) review a number of papers that use betting markets to measure market expectations.
Case studies t/a Business Finance 9e by Peirson et al.
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widened, with closing prices being $1.10 for the Coalition and $6 for the APL, indicating an 85%
probability of a Coalition win.7
Using the more conservative implied probability of 77% that the Coalition would win the election,
the estimated yield on the December 2004 three-year bond futures contract after the election had the
ALP been elected is therefore 5.59%. This provides a difference in three-year interest rates between
the possible election outcomes of 0.35%.
Conclusion
Contrary to the media commentary, the election outcome did affect interest rates.8
Questions
1. On 8 October 2004, the quoted price on the March 2005 90-day bank bill futures contract was
94.52. Margaret believed that, following the Australian Federal Government election on 9
October, interest rates would fall. Suppose that she bought eight contracts on 8 October and
closed out her position on 11 October at a price of 94.57. Ignoring transaction costs, how much
did Margaret make (or lose)?
2. On 8 October 2004, the December 2004 ten-year bond futures contract was priced at 94.435.
Michael believed that, following the Australian Federal Government election on 9 October,
interest rates would rise. Suppose that he sold two contracts on 8 October and closed out his
position on 11 October at a price of 94.525. Ignoring transaction costs, how much did Michael
make (or lose)?
3. On 8 October 2004, the November 2004 30-day interbank cash rate futures contract was priced
at 94.740, and on 11 October 2004 it was priced at 94.745. The Reserve Bank of Australia
(RBA) had a scheduled board meeting on 2 November 2004. Suppose we assume that the
decision faced by the RBA board was to either leave the target cash rate unchanged at 5.25 per
cent per annum or increase it to 5.5 per cent per annum. What were the implied probabilities, on
8 and 11 October, of the RBA board leaving the target cash rate unchanged on 2 November?
Source Age, 29 September 2004; Australian Financial Review, 25 September, 28 September and 11
October 2004; S. Easton and R. Gerlach (2005), ‘Interest rates and the 2004 Australian election’,
Australian Journal of Political Science, vol. 40, no. 4, pp. 559–66; E. Fama (1991), ‘Efficient
capital markets: II’, Journal of Finance, vol. 46, no. 5, 1575–1617; and G. Peirson, R. Brown, S.
Easton, P. Howard and S. Pinder (2005), Business Finance, 9th Edition, McGraw-Hill, Sydney;
Sydney Morning Herald, 25 September and 11 October 2004; J. Wolfers and A. Leigh (2002),
‘Three tools for forecasting federal elections: lessons from 2001’, Australian Journal of Political
Science, vol. 37, no. 2, pp. 223–40; and J. Wolfers and E. Zitzewitz (2004), ‘Predication markets’,
Journal of Economic Perspectives, vol. 18, no. 2, pp. 107–26.
For a discussion of the Centrebet election odds, see Leigh, A., ‘Betting experts know a slow horse’, Sydney Morning
Herald, 11 October 2004, p. 12, and Cloat, J., ‘Red faces as apples pip the oranges: polls and betting’, Australian
Financial Review, 11 October 2004, p. 20.
8
The All Ordinaries Index increased by 0.5% from 3696.0 on 8 October to 3714.6 on 11 October. Applying the same
analysis to equity prices as that applied to interest rates shows that had the Labor party won office the All Ordinaries
Index may have been expected to fall by 1.67% to 3634.
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Case studies t/a Business Finance 9e by Peirson et al.
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