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

Listed author(s):
  • Markku Lanne

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

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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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  1. 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.
  2. 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.
  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.
  4. Donald W.K. Andrews, 1986. "Power in Econometric Applications," Cowles Foundation Discussion Papers 800, Cowles Foundation for Research in Economics, Yale University.
  5. 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.
  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. Hansen, B.E., 1991. "Inference when a Nuisance Parameter is Not Identified Under the Null Hypothesis," RCER Working Papers 296, University of Rochester - Center for Economic Research (RCER).
  8. Newey, Whitney K & West, Kenneth D, 1987. "A Simple, Positive Semi-definite, Heteroskedasticity and Autocorrelation Consistent Covariance Matrix," Econometrica, Econometric Society, vol. 55(3), pages 703-708, May.
  9. Pierluigi Balduzzi & Giuseppe Bertola & Silverio Foresi, 1993. "A Model of Target Changes and the Term Structure of Interest Rates," NBER Working Papers 4347, National Bureau of Economic Research, Inc.
  10. 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.
  11. Evans, Martin D. D. & Lewis, Karen K., 1994. "Do stationary risk premia explain it all?: Evidence from the term structure," Journal of Monetary Economics, Elsevier, vol. 33(2), pages 285-318, April.
  12. Hansen,B.E., 1999. "Testing for linearity," Working papers 7, Wisconsin Madison - Social Systems.
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  14. Bekaert, Geert & Hodrick, Robert J. & Marshall, David A., 2001. "Peso problem explanations for term structure anomalies," Journal of Monetary Economics, Elsevier, vol. 48(2), pages 241-270, October.
  15. 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.
  16. 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.
  17. 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.
  18. 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.
  19. 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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