The relationship between short-term and forward interest rates: a structural time-series analysis

Abstract

In this paper, the structural time-series (STS) approach is used to examine the relationship between short-term and forward interest rates on US Treasury bills and, to decompose the biased predictions of the future short rate by the forward rate, into systematic expectation errors and systematic time-varying term premiums. Results confirm many of the empirical characteristics of short and forward rates and, findings reveal that both expectation errors and time-varying expected term premiums are important in explaining the forward rate bias.