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Interest rate expectations and the shape of the yield curve

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  • Joseph Dziwura
  • Eric M. Green

Abstract

According to the rational expectations hypothesis of the term structure (REHTS) long term rates should reflect market expectations for the average level of future short-term rates. The purpose of this paper is to examine whether REHTS assumptions conform to the term structure of outstanding U. S. Treasury securities from 1973 to 1995, and to examine the behavior of term premiums and to what extent they influence the shape of the forward curve. REHTS assumptions are re-examined using familiar regression tests to determine the forecast power of forward rates for subsequent spot rates, and we use excess holding period returns, the extra return earned on a security sold prior to maturity, as the ex poste measurement of the term premium. We find that forward rates explain only some of the variance in future spot rates, the forecast power of forward rates varies with maturity, and the term premia is time-varying. We decompose the forward rate into the current spot rate, a term premium, and an expected interest rate change, where the term premium is the sum of a risk premium and a convexity premium. We find that on average term premiums have contributed more to the shape of the forward curve than have expected rate changes, and find that expected and past interest rate volatility, as well as the slope of the yield curve, may provide information on the size of expected term premiums.

Suggested Citation

  • Joseph Dziwura & Eric M. Green, 1996. "Interest rate expectations and the shape of the yield curve," Research Paper 9631, Federal Reserve Bank of New York.
    • Handle: RePEc:fip:fednrp:9631
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    References listed on IDEAS

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    1. repec:onb:oenbwp:y::i:37:b:1 is not listed on IDEAS
    2. Alois Geyer & Richard Mader, 1999. "Estimation of the term structure of interest rates - A parametric approach," Working Papers 37, Oesterreichische Nationalbank (Austrian Central Bank).

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