DP4301 Financial Factors, Macroeconomic Information and the Expectations Theory of the Term Structure of Interest Rates

Author(s): Andrea Carriero , Carlo A Favero , Iryna Kaminska

Publication Date: March 2004

Keyword(s): E47 , expectations theory , macroeconomic information in finance

JEL(s): E43 , E44

Programme Areas: Financial Economics , International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP4301.asp

In this Paper we concentrate on the hypothesis that the empirical rejections of the Expectations Theory (ET) of the term structure of interest rates can be caused by improper modeling of expectations. Our starting point is an interesting anomaly found by Campbell-Shiller (1987), when by taking a VAR approach they abandon limited information approach to test the ET, in which realized returns are taken as a proxy for expected returns. We use financial factors and macroeconomic information to construct a test of the theory based on simulating investors’ effort to use the model in ‘real time’ to forecast future monetary policy rates. Our findings suggest that the importance of fluctuations of risk premia in explaining the deviation from the ET is reduced when some forecasting model for short-term rates is adopted and a proper evaluation of uncertainty associated to policy rates forecast is considered.