Repo rates as reference interest rates: testing the expectations hypothesis of the term structure of interest rates

Abstract

The subject of this paper is the consideration of the role of the repo market and the quality of repo rates in the formation of reference interest rates that would be used to assess the value of financial instruments and derivatives. Unsecured money markets carry a certain level of risk, thus, the question arises whether the existing reference interest rates should be replaced by repo rates or other interest rates on secured loans. Reference interest rates on the money market play an important role in a country's monetary policy. Through operations on the short-term money market, Central Banks try to influence interest rates with long maturities. One of the most well-known theories that considers the question of the relationship between short-term and long-term interest rates is the expectations hypothesis. In this paper, expectations hypothesis is tested on the example of daily data of overnight interest rates related to secured interbank loans. Two samples were used, and term premiums were estimated for both short-term (up to one year using LIBOR interest rates) and long-term maturities (from two to ten years using ICE swap interest rates). The hypothesis is tested using two econometric tests proposed by Campbell and Shiller (1991). The tests were also applied to the overnight interest rates of interbank loans that are not secured, in order to get a better comparative picture. The results show that collateralized interest rates are good indicators of benchmark interest rates, and in some cases even more accurate predictors of long-term interest rates.