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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 hypothesis can be tested by testing restrictions on the parameters of the term structure equation.The model can be estimated by maximum likelihood, given a method for computing the conditional expectation in the term structure equation. To this end we employ a common simulation method where, given, some fixed values of the parameters and initial values, a large number of realizations of the threshold autoregression for the short-term rate are simulated m(n/m-1) periods ahead (n is maturity of the longer-term rate), and the conditional expectations are obtained as averages over these realizations at each horizon. This is computationally burdensome (especially if n/m is large) since the simulation is required in the estimation at each iteration and for all observations t=1,...,T.The model is estimated and the expectations hypothesis is tested for monthly Eurodollar deposit rates for maturities 1, 3 and 6 months covering the period 1983:1-1999:6. Because we are assuming that no regime shifts have occurred in the sample, only the period after the abondonment of the 'new operating procedures' of the Federal Reserve in considered. The choice of maturities is dictated by the availability of data, and the computational complexity of our model which increases with the maturity of the longer-term interest rate. Classical regression based tests indicate rejection, while tests in the model allowing for potential regime shifts that have not realized in the sample period, lend support to the expectations hypothesis. The estimation results imply that the potential regime shift has affected the expectations concerning the longer-term interest rate only in a short period at the beginning of the sample where the interest rates were highest.

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Bibliographic Info

Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2000 with number 294.

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Date of creation: 05 Jul 2000
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Handle: RePEc:sce:scecf0:294

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Postal: CEF 2000, Departament d'Economia i Empresa, Universitat Pompeu Fabra, Ramon Trias Fargas, 25,27, 08005, Barcelona, Spain
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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. Hansen, Bruce E, 1999. " Testing for Linearity," Journal of Economic Surveys, Wiley Blackwell, vol. 13(5), pages 551-76, December.
  3. Geert Bekaert & Robert J. Hodrick & David A. Marshall, 1997. ""Peso Problem" Explanations for Term Structure Anomalies," NBER Working Papers 6147, National Bureau of Economic Research, Inc.
  4. Stefan Gerlach & Frank Smets, 1995. "The term structure of Euro-rates: some evidence in support of the expectations hypothesis," BIS Working Papers 28, Bank for International Settlements.
  5. Jääskelä, Jarkko & Vilmunen, Jouko, 1999. "Anticipated Monetary Policy and the Dynamic Behaviour of the Term Structure of Interest Rates," Research Discussion Papers 12/1999, Bank of Finland.
  6. Sola, Martin & Driffill, John, 1994. "Testing the term structure of interest rates using a stationary vector autoregression with regime switching," Journal of Economic Dynamics and Control, Elsevier, vol. 18(3-4), pages 601-628.
  7. 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.
  8. Geert Bekaert & Robert J. Hodrick & David Marshall, 1996. "On biases in tests of the expectations hypothesis of the term structure of interest rates," Working Paper Series, Issues in Financial Regulation WP-96-3, Federal Reserve Bank of Chicago.
  9. Balduzzi, Pierluigi & Bertola, Giuseppe & Foresi, Silverio, 1997. "A model of target changes and the term structure of interest rates," Journal of Monetary Economics, Elsevier, vol. 39(2), pages 223-249, July.
  10. repec:fth:bfsefi:12/99 is not listed on IDEAS
  11. 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.
  12. 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.
  13. 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.
  14. Hansen, Bruce E, 1996. "Inference When a Nuisance Parameter Is Not Identified under the Null Hypothesis," Econometrica, Econometric Society, vol. 64(2), pages 413-30, March.
  15. Francis X. Diebold & Joon-Haeng Lee & Gretchen C. Weinbach, 1993. "Regime switching with time-varying transition probabilities," Working Papers 93-12, Federal Reserve Bank of Philadelphia.
  16. Campbell, John Y & Shiller, Robert J, 1991. "Yield Spreads and Interest Rate Movements: A Bird's Eye View," Review of Economic Studies, Wiley Blackwell, vol. 58(3), pages 495-514, May.
  17. Andrews, Donald W K, 1989. "Power in Econometric Applications," Econometrica, Econometric Society, vol. 57(5), pages 1059-90, September.
  18. Clements, Michael P. & Smith, Jeremy, 1997. "The performance of alternative forecasting methods for SETAR models," International Journal of Forecasting, Elsevier, vol. 13(4), pages 463-475, December.
  19. Hamilton, James D., 1988. "Rational-expectations econometric analysis of changes in regime : An investigation of the term structure of interest rates," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 385-423.
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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. 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.
  3. 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.
  4. Balázs Romhányi, 2005. "A learning hypothesis of the term structure of interest rates," Macroeconomics 0503001, EconWPA.
  5. 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.
  6. 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.
  7. Erdemlioglu, Deniz, 2009. "Macro Factors in UK Excess Bond Returns: Principal Components and Factor-Model Approach," MPRA Paper 28895, University Library of Munich, Germany.

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