Significance of risk modelling in the term structure of interest rates

Abstract

This study examines the significance of risk modelling and asymmetries when researchers test the popular economic theories concerning the term structure of interest rates. A panel data set of returns on government bond portfolios was used and methods to account for related movements in risk premia across assets with different currency denomination were employed. Rather than attempting to model risk directly in terms of observables, the study has instead exploited an implication of the CAPM concerning how risk premia for a given maturity structure would vary through time in a related manner across different type of assets. In light of recent non-linear research in the area of term structure of interest rates the hypothesis is investigated that the spread effect might have a non-linear impact on excess holding period yield (EHPY). Non-linear effects of spread on EHPY were found in all the maturity structure exception being the short-term maturities. There was evidence for a mean reversion process of returns only for large spread effects in international bond markets. Concerning the rational expectation hypothesis the empirical work provides evidence against it. However, testing this hypothesis over the longer maturity bonds can be very sensitive to the modelling process of risk and possible asymmetries.

Acknowledgements

We would like to thank the anonymous referee and Giorgio Valente for their useful and constructive comments in our work. Any remaining errors are solely the authors’ responsibility. Stephanos Papadamou would also like to thank IKY Greek State Scholarships Foundation, for the funds provided in his postdoctoral research works.

Notes

¹ Note, however, that the approach is valid, based on the validity of the international CAPM framework.

² Once a numeraire currency is defined, then the expected holding period yield on an n-period bond and the one period risk free rate, will both include the same expected one period change in the exchange rate. That is, where is the expected one period change in logarithm of the exchange rate, with exchange rate being defined as the numeraire-currency price of the foreign currency.

³ Empirical results have been derived using EVIEWS.