Market Expectations of the Short Rate and the Term Structure of Interest Rates: A New Perspective from the Classic Model

Abstract

This paper develops a novel approach to measure the market expectations and term premia in the term structure of interest rates. Key components of this approach are generic impact measures of state variables in a Gaussian dynamic term structure model. These measures are inherent in a particular state variable regardless of how other state variables are defined within the model. With the help of these measures, the approach gives rise to market expectations predicting yield changes well, and term premia having a legitimate impact on the forward curve. In the empirical analysis, I show the generic impact of the short rate on the yield curve, and historical dynamics of market expectations and term premia. The calibrated model is also employed to study the impacts of recent unconventional monetary policies.