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Alternative Term Structure Models for Reviewing Expectations Puzzles

According to the expectations hypothesis, the forward rate is equal to the expected future short rate, an argument that is not supported by most empirical studies that demonstrate the existence of term premiums. An alternative arbitrage-free term structure model for reviewing the expectations hypothesis is presented and tractable expressions for time-varying term premiums are obtained. The model is constructed under the real-world probability measure and depends on two stochastic factors: the short rate and the market price of risk. The model suggests that for short maturities the short rate contribution determines the term premiums, while for longer maturities, the contribution of the market price of risk dominates.

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File URL: http://www.qfrc.uts.edu.au/research/research_papers/rp305.pdf
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Paper provided by Quantitative Finance Research Centre, University of Technology, Sydney in its series Research Paper Series with number 305.

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Length: 27
Date of creation: 01 Mar 2012
Date of revision:
Handle: RePEc:uts:rpaper:305
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  1. Harris, R., 1998. "The Expectations Hypothesis of the Term Structure and Time Varying Risk Premia: a Panel Data Approach," Discussion Papers 9811, Exeter University, Department of Economics.
  2. Eckhard Platen, 2003. "Modeling the Volatility and Expected Value of a Diversified World Index," Research Paper Series 103, Quantitative Finance Research Centre, University of Technology, Sydney.
  3. Eckhard Platen, 2001. "Arbitrage in Continuous Complete Markets," Research Paper Series 72, Quantitative Finance Research Centre, University of Technology, Sydney.
  4. Christiansen, Charlotte, 2001. "Long Maturity Forward Rates," Finance Working Papers 01-12, University of Aarhus, Aarhus School of Business, Department of Business Studies.
  5. Eckhard Platen, 2004. "A Benchmark Approach to Finance," Research Paper Series 138, Quantitative Finance Research Centre, University of Technology, Sydney.
  6. Truc Le & Eckhard Platen, 2006. "Approximating the Growth Optimal Portfolio with a Diversified World Stock Index," Research Paper Series 184, Quantitative Finance Research Centre, University of Technology, Sydney.
  7. Eckhard Platen, 2001. "A Minimal Financial Market Model," Research Paper Series 48, Quantitative Finance Research Centre, University of Technology, Sydney.
  8. Harris, Richard D F, 2001. " The Expectations Hypothesis of the Term Structure and Time-Varying Risk Premia: A Panel Data Approach," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 63(2), pages 233-45, May.
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