Alternative Term Structure Models for Reviewing Expectations Puzzles
Research Paper Number 305, Quantitative Finance Research Centre, University of Technology, Sydney
28 Pages Posted: 27 Oct 2012
Date Written: March 1, 2012
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.
Keywords: expectations hypothesis, time-varying term premiums, real-world probability measure, market price of risk
JEL Classification: G13
Suggested Citation: Suggested Citation