Long rates, risk premia and the over-reaction hypothesis

Abstract

We examine the possibility that the apparent failure of the expectations hypothesis EH on UK data at the long end of the maturity spectrum, may be due to the presence of a time varying (yet stationary) term premium. The presence of a time varying term premium (TVP) can result in the ‘over reaction hypothesis’ namely, that actual movements in the spread appear to be more volatile than expected changes in future short rates. We find, using UK data, that for very long maturities there is evidence of a time varying term premium which influences one-period excess holding period returns. The effect of this term premium on the coefficient of the spread in an equation which predicts the expected one-period change in long rates is sufficient to bias the results towards rejection of the EH. However, the impact of the average term premium on a weighted average of future short rates is relatively small, so that the spread is an unbiased predictor of future changes in short rates. Our analysis is conducted using a high quality UK data set for maturities of 2, 3, … 10 years and for 15, 20 and 25 years.