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Term spread regressions of the rational expectations hypothesis of the term structure allowing for risk premium effects

  • Efthymios Argyropoulos EMAIL logo and Elias Tzavalis
Published/Copyright: April 26, 2014

Abstract

This paper suggests a new empirical methodology of testing the predictions of the term spread between long and short-term interest rates about future changes of the former allowing for term premium effects, according to the rational expectations hypothesis of the term structure. To capture the effects of a time-varying term premium on the term spread, the paper relies on an empirically attractive affine Gaussian dynamic term structure model which assumes that the term structure of interest rates is spanned by three unobserved state variables. To retrieve accurate values of these variables from interest rates series, the paper suggests a new method which can overcome the effects of measurement (or pricing) errors inherent in these series on the estimates of the model. This method is assessed by a Monte Carlo study. Ignoring these errors will lead to biased estimates of term structure models. The empirical results of the paper provide support for the suggested term structure model. They show that this model can efficiently capture the time-varying term premium effects embodied in long-term interest rates, which can explain the failures of term spread to forecast future changes in long-term rates.

JEL: G12; E43

Corresponding author: Efthymios Argyropoulos, Athens University of Economics and Business (AUEB), Athens 104 34, Greece, e-mail:

Acknowledgments

The authors would like to thank the editor (Bruce Mizrach) and an anonymous referee for useful comments on an earlier version of the paper. The authors acknowledge financial support from the Basic Funding Research Program II (2011–2012) of AUEB.

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Supplemental Material

The online version of this article (DOI: 10.1515/snde-2012-0024) offers supplementary material, available to authorized users.


Published Online: 2014-4-26
Published in Print: 2015-2-1

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