The role of expectations and risk aversion in the term structure of interest rates : evidence from the treasury bill market
Date
1985
Authors
Cheung, Irene Nga Yi
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Abstract
Market rates of interest for various types of debt instruments may differ for a number of reasons. One of the major causes of differences is the term to maturity, that is, the length of time over which a debt instrument is scheduled to be redeemed by the issuer. The relationship between interest rate (yield) and term to maturity on debt instruments that have otherwise identical characteristics is termed the 'term structure of interest rates'. Various theories have been advanced to account for this relationship, namely, the pure expectations theory, the market segmentation theory, the risk-premium theory and the preferred habitat theory.
This thesis is devoted to the study of the role and relative importance of expectations and risk aversion in the determination of the term structure. Focusing on the very short end of the Canadian bond market, the Treasury bill market, the empirical findings provide strong evidence in support of the importance of interest-rate expectations in the term structure of interest rates. In particular, results of different tests confirm that expectations are shaped by regressive forces, that is, interest rates are expected to regress toward a long-run normal level based on past experience. The empirical findings also indicate that the market does not price debts of different maturities in such a way that the forward rates implied in the empirical term structure are equivalent to the expected future rates. Instead, forward rates are found to be upward biased estimates of expected future rates, exceeding them by a positive risk premium. Additional tests on the risk premium reveal that it is inversely related to the current interest rate but directly related to the interest rate of the previous period. However, there is a lack of sufficient evidence that it increases with the term to maturity. While it is difficult to quantify the amount of influence of market segmentation on the term structure based on the empirical results, its impact on the term structure does not appear to be substantial. The implications of these findings to policy-makers in the pursuit of maintaining a certain degree of control over the term structure is that it is possible for the government to shift and to alter the shape of a yield curve by open market operations. However, in view of the general conclusion that interest-rate expectations are the dominant and a more important factor than both risk aversion and market segmentation in determining the term structure, it is easier for the monetary authorities to shift than to alter the shape of a yield curve appreciably, and the effects of monetary operations will be transmitted through the entire maturity continuum without significant lags.