Abstract
This paper re-examines the validity of the Expectation Hypothesis (EH) of the term structure of US repo rates ranging in maturity from overnight to three months. We extend the work of Longstaff (2000) in two directions: (i) we implement statistical tests designed to increase test power in this context; (ii) we assess the economic value of departures from the EH based on criteria of profitability and economic significance. The EH is rejected throughout the term structure examined on the basis of the statistical tests. The results of our economic analysis are less uniform and more favorable to the EH, suggesting that the statistical rejections of the EH are not economically significant for rates with maturities of one month and longer.
Highlights
Ever since Fisher (1896) postulated the expectation hypothesis (EH) of the term structure of interest rates, this simple and intuitively appealing theory has attracted an enormous amount of attention in ...nancial economics
Speci...cally, the evidence in this paper shows that the economic value of departures from the EH is modest and generally smaller than the costs that an investor would incur if he were to trade to exploit the mispricing implied by EH violations
This paper reexamines an important exception in this literature: the result that the EH appears to ...t the behavior of US repo rates at the shortest end of the term structure, measured at daily frequency from overnight to the three-month maturity (Longsta¤, 2000b)
Summary
Ever since Fisher (1896) postulated the expectation hypothesis (EH) of the term structure of interest rates, this simple and intuitively appealing theory has attracted an enormous amount of attention in ...nancial economics. This maintained assumption is questionable due to the well-documented limitations of a¢ ne speci...cations in matching the level and term premium in bonds simultaneously with the volatility of interest rates These caveats notwithstanding, in this paper we rely on the VAR testing framework developed by Bekaert and Hodrick (2001) because of its desirable power properties in presence of highly nonlinear restrictions. Eq (6) does not have a straightforward intuition, it gives a 2p dimensional vector of restrictions, nonlinear in the underlying parameters of , such that the predictions of future short-term rates are consistent with the EH and the resulting constrained VAR collapses to Eq (1) We can interpret these restrictions as a concise summary of the main implications stated by the theory. Where is formed by collecting the relevant parameters of the companion matrix .10
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