Working Paper: CEPR ID: DP4301
Authors: Andrea Carriero; Carlo A. Favero; Iryna Kaminska
Abstract: 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.
Keywords: expectations theory; macroeconomic information; finance
JEL Codes: E43; E44; E47
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Improper modeling of expectations (C51) | Rejection of the expectations theory (ET) (D84) |
| Improved forecasting (C53) | Diminished role of risk premia (G19) |
| Simultaneous equation approach (C30) | Better understanding of expectations errors and validity of the ET (C52) |
| Forecasting errors about future policy rates (E47) | Independent identification of risk premia (G19) |
| Deviations from expected yields (C29) | Forecasting errors (C53) |