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The Impossibility of Stationary Yield Spreads and I(1) Yields under the Expectations Theory of the Term Structure

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Abstract

It is a widely encountered misconception that the vector of spreads between longer-term interest rates and the short rate is stationary under the Expectations Theory (ET). By considering a complete term structure of maturities it is shown that the ET determines the conditional mean of the VAR process followed by the yield curve. We prove that under this process, the zero-coupon yield curve is I(2), immediately casting doubt on the empirical usefulness of the ET. Furthermore, the yield spreads are shown to be a non-stationary, cointegrated I(1) process. This result invalidates many existing approaches to evaluating and formally testing the ET. Finally, time series features of yield curve data simulated under the ET are compared with those of actual US Treasury zero-coupon yield curves.

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Bibliographic Info

Paper provided by Economics Group, Nuffield College, University of Oxford in its series Economics Papers with number 2006-W05.

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Length: 17 pages
Date of creation: 08 Jun 2006
Date of revision:
Handle: RePEc:nuf:econwp:0605

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Web page: http://www.nuff.ox.ac.uk/economics/

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Keywords: Expectations theory; term structure; yield curve; I(2) process; I(1) process; cointegration.;

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  1. Diebold, Francis X. & Li, Canlin, 2003. "Forecasting the term structure of government bond yields," CFS Working Paper Series 2004/09, Center for Financial Studies (CFS).
  2. Fama, Eugene F & Bliss, Robert R, 1987. "The Information in Long-Maturity Forward Rates," American Economic Review, American Economic Association, vol. 77(4), pages 680-92, September.
  3. Andrea Carriero & Carlo Favero & Iryna Kaminska, 2004. "Financial Factors, Macroeconomic Information and the Expectations Theory of the Term Structure of Interest Rates," Working Papers 253, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  4. John H. Cochrane & Monika Piazzesi, 2002. "Bond Risk Premia," NBER Working Papers 9178, National Bureau of Economic Research, Inc.
  5. Shea, Gary S, 1992. "Benchmarking the Expectations Hypothesis of the Interest-Rate Term Structure: An Analysis of Cointegration Vectors," Journal of Business & Economic Statistics, American Statistical Association, vol. 10(3), pages 347-66, July.
  6. Shiller, Robert & Campbell, John, 1991. "Yield Spreads and Interest Rate Movements: A Bird's Eye View," Scholarly Articles 3221490, Harvard University Department of Economics.
  7. Pagan, A.R. & Hall, A.D. & Martin, V., 1995. "Modelling the Term Structure," Papers 284, Australian National University - Department of Economics.
  8. Campbell, John Y & Shiller, Robert J, 1987. "Cointegration and Tests of Present Value Models," Journal of Political Economy, University of Chicago Press, vol. 95(5), pages 1062-88, October.
  9. Hall, Anthony D & Anderson, Heather M & Granger, Clive W J, 1992. "A Cointegration Analysis of Treasury Bill Yields," The Review of Economics and Statistics, MIT Press, vol. 74(1), pages 116-26, February.
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Cited by:
  1. Clive Bowsher & Roland Meeks, 2006. "High Dimensional Yield Curves: Models and Forecasting," Economics Series Working Papers 2006-FE-11, University of Oxford, Department of Economics.
  2. Clive G. Bowsher & Roland Meeks, 2008. "The Dynamics of Economic Functions: Modelling and Forecasting the Yield Curve," Economics Papers 2008-W05, Economics Group, Nuffield College, University of Oxford.

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