The nature of risk premia in the term-structure of interest rates
Document ID: 2008-1229 (previously 2008/86)
Published on: 1st December 2008
Author: Peter Raftopulos and Steffen Sorensen
This paper investigates the validity of the expectations hypothesis of interest rates in the UK; the US and Germany using simple regression analysis. The analysis is carried out in three stages using forward rates of a maturity between 1- and 25-year horizons using a data set covering the past 50 years. Employing forward-spot spread regressions, we find little empirical support for the expectations hypothesis, i.e. that current forward interest rates are a perfect predictor of future interest rates. Modelling the risk premium as a function of time-varying macro volatilities we do find some evidence of a time-varying risk premium. But even when adjusting the forward rates for this risk premium we find that expectations hypothesis still does not hold at all maturities.
While this obviously suggest that our risk premium model may be wrong, our analysis highlights an important challenge for yield curve modelling – there is a lot of uncertainty whether the term-structure of interest rates embeds term premia though empirical evidence does suggest that, on average, the longer the maturity of the bond the higher the forward rate, on average, has been above the realised future policy out come.
