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

  • 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. 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. Geert Bekaert & Robert J. Hodrick & David A. Marshall, 1996. "On Biases in Tests of the Expecations Hypothesis of the Term Structure Of Interest Rates," NBER Technical Working Papers 0191, National Bureau of Economic Research, Inc.
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  5. 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.
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  15. 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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