Essential Classes of Interest Rate Models and Their Use

We examine and test the validity of the expectation hypothesis of the term structure (EHTS) of interest rates in Saudi Arabia using the traditional single equation approach, Campbell and Shiller methodology, Error Correction Model, and monthly data over the period June 1983 to December 2014. The results of the single equation approach indicate that the test of validity of the expectation hypothesis cannot be rejected for all maturities. We also find that the validity of the EHTS of interest rates is supported through the stationarity of the term spreads between short- and long-term interest rates. Moreover, the cointegration test reveals the existence of a cointegration relationship between short- and long-term interest with ( 1 − 1 ) $\left(1-1\right)$ cointegrating vector, suggesting the validity EHTS of interest rates. Policy implications based on the empirical results suggest that the transparency of monetary policy in Saudi Arabia and the effective role of the Saudi Arabian Monetary Authority (SAMA) in conducting monetary policy increase the predictive power of market participants of future movements of short-term interest rates.

Direct Estimation of the Risk Neutral Factor Dynamics of Affine Term Structure Models

Government Bonds and the Term Structure of Interest Rates

Macro-finance theory implies that trend inflation and the equilibrium real interest rate are fundamental determinants of the yield curve. However, empirical models of the term structure of interest rates generally assume that these fundamentals are constant. We show that accounting for time variation in these underlying long-run trends is crucial for understanding the dynamics of Treasury yields and predicting excess bond returns. We introduce a new arbitrage-free model that captures the key role that long-run trends play in determining interest rates. The model also provides new, more plausible estimates of the term premium and accurate out-of-sample yield forecasts. (JEL E31, E43, E47)

On biases in tests of the expectations hypothesis of the term structure of interest rates

Modeling the Term Structure of Interest Rates: Where Do We Stand?

A Fresh View on the Ho-Lee Model of the Term Structure from a Stochastic Discounting Perspective

Term Structure of Interest Rates. Review of a Theory of the Term Structure of Interest Rates (CIR)

The APT Model and Variations in the Term Structure of Interest Rates

The aim of this paper is twofold; first we concentrate on the work of Vasicek (1977) and Cox, Ingersoll and Ross (1985). We examine and test empirically each model and discuss its performance in predicting the term structure of interest rates using a parametric estimating approach GMM (Generalized Moments Method). Second we estimate the term structure of interest rate dynamics using a nonparametric approach ANN (Artificial Neural Network). Two neural network models are performed. The first model uses spreads between interest rates of 10 different maturities as the only explanatory variable of interest rate changes. The second model introduces two factors, spreads and interest rates' levels. Using historical U.S. Treasury bill rates and Treasury bond yields, we compare the ability of each model to predict the term structure of interest rates. Data are daily and cover the period from 3 January 1995 to 29 December 2000. Results suggest that neural network, Vasicek (1977) and Cox, Ingersoll and Ross (1985) models generate different yield curves. Neural network models outperform the parametric standard models. The most successful forecast is obtained with a two factors neural network model.

The integration of emerging economies with developed economies has changed the behaviour of interest rates and exchange rate fluctuation. The current study tries to analyse the implication of expectation hypothesis (EH) and term structures of interest rates between India and US. Using vector auto regressive estimates, the study tries to test the dynamic interdependence of interest rates on exchange rate fluctuation. Further, the study estimates Granger causality tests and Impulse Response Functions to test the behaviour of interest rate movements for a period of nineteen years ranging from June 1996 to June 2015.The empirical results of the study show evidence in line with the existence of EH in the case of emerging market. Nevertheless, in the case of advanced economies we do not find any evidence for EH. The findings revealed that the spread between long and short rate of India is influenced by short-term interest rates and past values of Indian spread. This implies that the fluctuations in the long rate over the short rate evidenced the strong presence of EH as far as emerging economy is concerned.To the best of our knowledge, this is the first study in Indian market, which tests the role of EH in interest rate fluctuations along with exchange rate. Since majority of the studies on term structure of interest rates focus on developed markets, the present study is an attempt to test the causal relationship between developed and developing economies.

A consumption-based model of the term structure of interest rates

The paper develops an empirical no-arbitrage Gaussian affine term structure model to explain the dynamics of the German term structure of interest rates. In contrast to most affine term structure models two risk factors are linked to observable macroeconomics factors: output and inflation. The results indicate that the dynamics of the German term structure of interest rates can be sufficiently explained by expected variations in those macroeconomic factors plus an additional unobservable factor. Furthermore, we are able to extract a monetary policy reaction function within this no-arbitrage model that closely resembles empirical reaction functions that are based on the dynamics of the short rate only.

This thesis is an empirical study on the expectations theory of the term structure of interest rates in Australia over the period of 1984 to 2005. We examine the order of integration of bank accepted bills and treasury bonds yields using techniques that admit a structural break under the null and/or alternative hypothesis of the unit root tests. The results from these tests are matched against idiosyncratic economic events that occurred within and outside of the Australian economy. In addition, we investigate if the cointegrating relationship implied by the expectations hypothesis of the term structure of interest rates is consistent, whether or not an allowance for a structural break is made. The results support the expectation hypothesis based on Australian interest rate data, as there is sufficient evidence to support a cointegrating relationship between short and long term rates, which is robust to the presence of structural breaks.

Recent empirical research shows that a reasonable characterization of federal-funds-rate targeting behavior is that the change in the target rate depends on the maturity structure of interest rates and exhibits little dependence on lagged target rates. See, for example, Cochrane and Piazzesi (2002). The result echoes the policy rule used by (1994) to rationalize the empirical failure of the `expectations hypothesis' applied to the term- structure of interest rates. That is, rather than forward rates acting as unbiased predictors of future short rates, the historical evidence suggests that the correlation between forward rates and future short rates is surprisingly low. showed that a desire by the monetary authority to adjust short rates in response to exogenous shocks to the term premiums imbedded in long rates (i.e. yield-curve smoothing), along with a desire for smoothing interest rates across time, can generate term structures that account for the puzzling regression results of Fama and Bliss (1987). also clearly pointed out that this reduced-form approach to the policy rule, although naturally forward looking, needed to be studied further in the context of other response functions such as the now standard Taylor (1993) rule. We explore both the robustness of McCallum's result to endogenous models of the term premium and also its connections to the Taylor Rule. We model the term premium endogenously using two different models in the class of affine term structure models studied in Duffie and Kan (1996): a stochastic volatility model and a stochastic price-of- risk model. We then solve for equilibrium term structures in environments in which interest rate targeting follows a rule such as the one suggested by (i.e., the McCallum Rule). We demonstrate that McCallum's original result generalizes in a natural way to this broader class of models. To understand the connection to the Taylor Rule, we then consider two structural macroeconomic models which have reduced forms that correspond to the two affine models and provide a macroeconomic interpretation of abstract state variables (as in Ang and Piazzesi (2003)). Moreover, such structural models allow us to interpret the parameters of the term-structure model in terms of the parameters governing preferences, technologies, and policy rules. We show how a monetary policy rule will manifest itself in the equilibrium asset-pricing kernel and, hence, the equilibrium term structure. We then show how this policy can be implemented with an interest-rate targeting rule. This provides us with a set of restrictions under which the Taylor and Rules are equivalent in the sense if implementing the same monetary policy. We conclude with some numerical examples that explore the quantitative link between these two models of monetary policy.