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The Expectation Hypothesis of the Term Structure of Very Short-Term Rates: Statistical Tests and Economic Value

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  • Della Corte, Pasquale
  • Sarno, Lucio
  • Thornton, Daniel L

Abstract

This paper re-examines the validity of the Expectation Hypothesis (EH) of the term structure of US repo rates ranging in maturity from overnight to three months. We extend the work of Longstaff (2000a) in two directions: (i) we implement statistical tests designed to increase test power in this context; (ii) more importantly, we assess the economic value of departures from the EH based on criteria of profitability and economic significance in the context of a simple trading strategy. The EH is rejected throughout the term structure examined on the basis of the statistical tests. However, the results of our economic analysis are favorable to the EH, suggesting that the statistical rejections of the EH in the repo market are economically insignificant.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6445.

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Date of creation: Sep 2007
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Handle: RePEc:cpr:ceprdp:6445

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Keywords: economic value; expectation hypothesis; term structure of interest rates; vector autoregression;

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Citations

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Cited by:
  1. Daniel L. Thornton, 2009. "How did we get to inflation targeting and where do we go now? a perspective from the U.S. experience," Working Papers 2009-038, Federal Reserve Bank of St. Louis.
  2. Della Corte, Pasquale & Sarno, Lucio & Tsiakas, Ilias, 2011. "Spot and forward volatility in foreign exchange," Journal of Financial Economics, Elsevier, Elsevier, vol. 100(3), pages 496-513, June.
  3. Carlo Altavilla & Raffaella Giacomini & Riccardo Costantini, 2013. "Bond returns and market expectations," CeMMAP working papers, Centre for Microdata Methods and Practice, Institute for Fiscal Studies CWP20/13, Centre for Microdata Methods and Practice, Institute for Fiscal Studies.
  4. Eichengreen, Barry & Mody, Ashoka & Nedeljkovic, Milan & Sarno, Lucio, 2012. "How the Subprime Crisis went global: Evidence from bank credit default swap spreads," Journal of International Money and Finance, Elsevier, Elsevier, vol. 31(5), pages 1299-1318.
  5. Della Corte, Pasquale & Sarno, Lucio & Sestieri, Giulia, 2010. "The Predictive Information Content of External Imbalances for Exchange Rate Returns: How Much Is It Worth?," CEPR Discussion Papers, C.E.P.R. Discussion Papers 8045, C.E.P.R. Discussion Papers.
  6. Kotomin, Vladimir, 2011. "A test of the expectations hypothesis in very short-term international rates in the presence of preferred habitat for liquidity," The Quarterly Review of Economics and Finance, Elsevier, Elsevier, vol. 51(1), pages 49-55, February.
  7. Daniel L. Thornton, 2012. "Monetary policy: why money matters, and interest rates don’t," Working Papers 2012-020, Federal Reserve Bank of St. Louis.
  8. Karstanje, Dennis & Sojli, Elvira & Tham, Wing Wah & van der Wel, Michel, 2013. "Economic valuation of liquidity timing," Journal of Banking & Finance, Elsevier, vol. 37(12), pages 5073-5087.
  9. Buraschi Andrea & Carnelli Andrea, 2013. "The economic value of predictability in portfolio management," Journal of Financial Management, Markets and Institutions, Società editrice il Mulino, Società editrice il Mulino, issue 1, pages 11-25, January.
  10. Rime, Dagfinn & Sarno, Lucio & Sojli, Elvira, 2010. "Exchange rate forecasting, order flow and macroeconomic information," Journal of International Economics, Elsevier, vol. 80(1), pages 72-88, January.
  11. Massimo Guidolin & Daniel L. Thornton, 2010. "Predictions of short-term rates and the expectations hypothesis," Working Papers 2010-013, Federal Reserve Bank of St. Louis.
  12. Stephen Hall & Kavita Sirichand, 2010. "Decision-Based Forecast Evaluation of UK Interest Rate Predictability," Discussion Papers in Economics 10/09, Department of Economics, University of Leicester.
  13. Hernandis, Lucía & Torró, Hipòlit, 2013. "The information content of Eonia swap rates before and during the financial crisis," Journal of Banking & Finance, Elsevier, vol. 37(12), pages 5316-5328.
  14. Stephen Hall & Kavita Sirichand, 2010. "Economic Value of Stock and Interest Rate Predictability in the UK," Discussion Papers in Economics 10/13, Department of Economics, University of Leicester.

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