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Testing the Expectations Hypothesis of the Term Structure of Interest Rates in the Presence of a Potential Regime Shift

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  • Markku Lanne

Abstract

According to the classical expectations hypothesis of the term structure of interest rates, long-term interest rates are determined by the expectations of the future short-term interest rate. This hypothesis is typically rejected, especially with U.S. data. One explanation that has recently been offered for this rejection is the presence of so called peso effects that influece the distribution of the typically used test statistics. The term 'peso effect' refers to potential regime shifts in the process of the short-term rate that occur less frequently in the actual sample than they should according to the probability distribution of the process. Even if there were not a single regime shift in the observed data, the fact that these shifts have a positive probability, affects the expectations that the market forms of the future short-term rates, and thus the data seems to be irreconcilable with the expectations hypothesis.Previous term structure literature has mainly attempted to take the effect of regime switches into account by testing the rational expectations restrictions within models with more than one regime, typically the so called Markov switching models. These models are not applicable, however, if no regime shift has actually occurred in the sample period. In this paper we consider a model where no regime shift has occurred but the agents form expectations based on a nonlinear model allowing for such shifts. The model consists of a term structure equation implied by the expectations hypothesis, a threshold autoregression for the short-term (m-period) interest rate, and the restriction that the upper regime never occurs in the sample. Thus in the sample the threshold autoregression reduces to an AR model, but presence of a threshold term affects expectations. The selection of the threshold variable can be based on statistical criteria; in our empirical application the lagged level of the short-term interest rate turned out to be the best. The expectations hy

(This abstract was borrowed from another version of this item.)

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Bibliographic Info

Article provided by University of Manchester in its journal The Manchester School.

Volume (Year): 71 (2003)
Issue (Month): Supplement (09)
Pages: 54-67

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Handle: RePEc:bla:manchs:v:71:y:2003:i:supplement:p:54-67

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References

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  1. Pierluigi Balduzzi & Giuseppe Bertola & Silverio Foresi & Leora Klapper, 1997. "Interest Rate Targeting and the Dynamics of Short-Term Rates," NBER Working Papers 5944, National Bureau of Economic Research, Inc.
  2. Saikkonen, Pentti & Ripatti, Antti, 1999. "On the Estimation of Euler Equations in the Presence of a Potential Regime Shift," Research Discussion Papers 6/1999, Bank of Finland.
  3. Kugler, Peter, 1996. "The term structure of interest rates and regime shifts: Some empirical results," Economics Letters, Elsevier, vol. 50(1), pages 121-126, January.
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  6. Bekaert, Geert & Hodrick, Robert J. & Marshall, David A., 1997. "On biases in tests of the expectations hypothesis of the term structure of interest rates," Journal of Financial Economics, Elsevier, vol. 44(3), pages 309-348, June.
  7. Newey, Whitney & West, Kenneth, 2014. "A simple, positive semi-definite, heteroscedasticity and autocorrelation consistent covariance matrix," Applied Econometrics, Publishing House "SINERGIA PRESS", vol. 33(1), pages 125-132.
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  14. Markku Lanne, 1999. "Near Unit Roots And The Predictive Power Of Yield Spreads For Changes In Long-Term Interest Rates," The Review of Economics and Statistics, MIT Press, vol. 81(3), pages 393-398, August.
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Cited by:
  1. Osmani Teixeira De Carvalho Guillen & Benjamin M. Tabak, 2009. "Characterising the Brazilian term structure of interest rates," International Journal of Monetary Economics and Finance, Inderscience Enterprises Ltd, vol. 2(2), pages 103-114.
  2. Minoas Koukouritakis, 2010. "Structural breaks and the expectations hypothesis of the term structure: evidence from Central European countries," Review of World Economics (Weltwirtschaftliches Archiv), Springer, vol. 145(4), pages 757-774, January.
  3. Koukouritakis, Minoas, 2013. "Expectations hypothesis in the context of debt crisis: Evidence from five major EU countries," Research in Economics, Elsevier, vol. 67(3), pages 243-258.
  4. Balázs Romhányi, 2005. "A learning hypothesis of the term structure of interest rates," Macroeconomics 0503001, EconWPA.
  5. Erdemlioglu, Deniz, 2009. "Macro Factors in UK Excess Bond Returns: Principal Components and Factor-Model Approach," MPRA Paper 28895, University Library of Munich, Germany.
  6. Nagayasu, Jun, 2002. "On the term structure of interest rates and inflation in Japan," Journal of Economics and Business, Elsevier, vol. 54(5), pages 505-523.
  7. Date, Paresh & Wang, Chieh, 2009. "Linear Gaussian affine term structure models with unobservable factors: Calibration and yield forecasting," European Journal of Operational Research, Elsevier, vol. 195(1), pages 156-166, May.

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