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Alternative Term Structure Models for Reviewing Expectations Puzzles

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Abstract

According to the expectations hypothesis, the forward rate is equal to the expected future short rate, an argument that is not supported by most empirical studies that demonstrate the existence of term premiums. An alternative arbitrage-free term structure model for reviewing the expectations hypothesis is presented and tractable expressions for time-varying term premiums are obtained. The model is constructed under the real-world probability measure and depends on two stochastic factors: the short rate and the market price of risk. The model suggests that for short maturities the short rate contribution determines the term premiums, while for longer maturities, the contribution of the market price of risk dominates.

Suggested Citation

  • Christina Nikitopoulos-Sklibosios & Eckhard Platen, 2012. "Alternative Term Structure Models for Reviewing Expectations Puzzles," Research Paper Series 305, Quantitative Finance Research Centre, University of Technology, Sydney.
    • Handle: RePEc:uts:rpaper:305
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    File URL: https://www.uts.edu.au/sites/default/files/qfr-archive-03/QFR-rp305.pdf
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    1. Della Corte, Pasquale & Sarno, Lucio & Thornton, Daniel L., 2008. "The expectation hypothesis of the term structure of very short-term rates: Statistical tests and economic value," Journal of Financial Economics, Elsevier, vol. 89(1), pages 158-174, July.
    2. F. A. Lutz, 1940. "The Structure of Interest Rates," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 55(1), pages 36-63.
    3. Eckhard Platen, 2004. "Modeling The Volatility And Expected Value Of A Diversified World Index," International Journal of Theoretical and Applied Finance (IJTAF), World Scientific Publishing Co. Pte. Ltd., vol. 7(04), pages 511-529.
    4. Platen, Eckhard, 2000. "A minimal financial market model," SFB 373 Discussion Papers 2000,91, Humboldt University of Berlin, Interdisciplinary Research Project 373: Quantification and Simulation of Economic Processes.
    5. Eckhard Platen, 2006. "A Benchmark Approach To Finance," Mathematical Finance, Wiley Blackwell, vol. 16(1), pages 131-151, January.
    6. Christiansen, Charlotte, 2001. "Long Maturity Forward Rates," Finance Working Papers 01-12, University of Aarhus, Aarhus School of Business, Department of Business Studies.
    7. Eckhard Platen, 2001. "Arbitrage in Continuous Complete Markets," Research Paper Series 72, Quantitative Finance Research Centre, University of Technology, Sydney.
    8. Truc Le & Eckhard Platen, 2006. "Approximating the Growth Optimal Portfolio with a Diversified World Stock Index," Research Paper Series 184, Quantitative Finance Research Centre, University of Technology, Sydney.
    9. Harris, Richard D F, 2001. "The Expectations Hypothesis of the Term Structure and Time-Varying Risk Premia: A Panel Data Approach," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 63(2), pages 233-245, May.
    10. Harris, R., 1998. "The Expectations Hypothesis of the Term Structure and Time Varying Risk Premia: a Panel Data Approach," Discussion Papers 9811, University of Exeter, Department of Economics.
    11. Dai, Qiang & Singleton, Kenneth J., 2002. "Expectation puzzles, time-varying risk premia, and affine models of the term structure," Journal of Financial Economics, Elsevier, vol. 63(3), pages 415-441, March.
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    More about this item

    Keywords

    expectations hypothesis; time-varying term premiums; real-world probability measure; market price of risk;
    All these keywords.

    JEL classification:

    • G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing

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