Fractional Integration and Cointegration: Testing the Term Structure of Interest Rates

The expectation hypothesis suggests there exists long run equilibrium of interest rate term structure. Two theoretical approaches proposed by Campbell and Shiller (1987) and Hall el al. (1992) suggest that the term spread of long-term and short-term interest rates should be a stationary I(0) process. However, an empirically non stationary term spread or rejection of cointegration between long and short interest rates, in the traditional sense need not to be considered against the simple theoretical model. It is likely that the dichotomy between I(1) or I(0) and/or integer values of cointegration are environments which are too restrictive to model the term structure. In this paper, we evaluate and apply some recent techniques on testing fractional integration and propose the use of a residual based approach which uses the Exact Local Whittle Estimator. The method is then used to investigate the term structure in the UK and the US.