The Econometrics of Yield Spreads in the Money Market: A Note

Posted: 31 Jan 2002

See all articles by Sumon K. Bhaumik

Sumon K. Bhaumik

Aston University - Aston Business School; Institute for the Study of Labor (IZA); University of Michigan at Ann Arbor - Stephen M. Ross School of Business, William Davidson Institute

Dipankor Coondoo

Indian Statistical Institute, New Delhi - Economic Research Unit

Abstract

The literature on bond markets and interest rates has focused largely on the term structure of interest rates, specifically, on the so-called expectations hypothesis. At the same time, little is known about the nature of the spread of the interest rates in the money market beyond the fact that such spreads are generally unstable. However, with the evolution of complex financial instruments, it has become imperative to identify the time series process that can help one accurately forecast such spreads into the future. This paper explores the nature of the time series process underlying the spread between 3-month and 1-year US rates, and concludes that the movements in this spread over time is best captured by a GARCH(1,1) process. It also suggests the use of a relatively long term measure of interest rate volatility as an explanatory variable. This exercise has gained added importance in view of the revelation that GARCH based estimates of option prices consistently outperform the corresponding estimates based on the stylized Black-Scholes algorithm.

Keywords: Expectations hypothesis, yield spread, money market, conditional heteroskedasticity

JEL Classification: C22, C52, G0

Suggested Citation

Bhaumik, Sumon K. and Coondoo, Dipankor, The Econometrics of Yield Spreads in the Money Market: A Note. Available at SSRN: https://ssrn.com/abstract=296493

Sumon K. Bhaumik (Contact Author)

Aston University - Aston Business School ( email )

Aston Triangle
Birmingham, West Midlands B47ET
United Kingdom

Institute for the Study of Labor (IZA) ( email )

Schaumburg-Lippe-Str. 7 / 9
Bonn, D-53072
Germany

University of Michigan at Ann Arbor - Stephen M. Ross School of Business, William Davidson Institute

724 E. University Ave.
Wyly Hall
Ann Arbor, MI 48109-1234
United States

Dipankor Coondoo

Indian Statistical Institute, New Delhi - Economic Research Unit ( email )

203 B. T. Road
Calcutta, 700 035
India

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