Working Paper: CEPR ID: DP6445
Authors: Pasquale Della Corte; Lucio Sarno; Daniel L. Thornton
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 (2000a) in two directions: (i) we implement statistical tests designed to increase test power in this context; (ii) more importantly, we assess the economic value of departures from the EH based on criteria of profitability and economic significance in the context of a simple trading strategy. The EH is rejected throughout the term structure examined on the basis of the statistical tests. However, the results of our economic analysis are favorable to the EH, suggesting that the statistical rejections of the EH in the repo market are economically insignificant.
Keywords: economic value; expectation hypothesis; term structure of interest rates; vector autoregression
JEL Codes: E43; G10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Statistical rejections (C12) | Economic analysis provides support for EH (D12) |
| Statistical rejections (C12) | Economic value of exploiting departures from EH is modest (D46) |
| EH provides a useful framework for understanding interest rate movements (E43) | EH remains reasonable approximation for term structure of repo rates (E43) |
| Deviations from EH (D59) | Do not yield significant economic gains when accounting for transaction costs (G19) |
| Expectation Hypothesis (EH) statistically rejected (C51) | Statistical properties of data do not conform to EH (C46) |