Term Structure Models

The term spread is defined as the difference between long and short rates and models expectations of forthcoming changes in short rates. As a consequence, a modified version of the spread should be positively correlated to the change in the long rate over the short term for a given maturity, with a regression coefficient equal to unity. Static yield curve regressions for the Euro area in the 2004m09–2018m08 sample period show that the term spread predicts holding period returns, rather than changes in long rates, since estimated slope coefficients are negative. The yield curve regression findings provide evidence of return extrapolation of Euro area investors in the formation of expectations on the term structure of interest rates. A behavioural interpretation of return extrapolation is based on the heuristic rules framework. Similarly, the difference between forward rates and current spot rates should be positively correlated to changes in spot rates over the forward rate horizon. In forward rate regressions the slope coefficient estimates are consistent with the expectations hypothesis. A distinguishing feature of the forward rate regressions is their well-defined dynamic structure.