Econometric methods of analysis and forecasting of financial markets Lecture 9. Interest rates theory

This lecture helps to understand: The main hypotheses explaining the term structure of interest rates Empirical estimation of interest rates hypotheses

Contents Useful definitions Term structure of interest rate Yield curve Pure expectations theory Liquidity preference theory Market segmentation theory Preferred habitat theory Empirical estimation of term structure hypotheses

Useful definitions Bond: debt security with the payment in nominal (monetary units) or real (for example, by the index of consumer prices) values. 2 types: -discount bond: security with the income calculated as the difference (discount) between the buying price of bond and its par value under maturity. -coupon bond: security with the income calculated as the sum of coupon payments over the period of bond circulation and, probably, positive or negative discount between the buying price of bond and its par value under maturity. We consider only discount bonds.

Useful definitions

Term structure of interest rates

Yield curve Yield curve is the graph which presents the relation between yields with different maturities and terms (times to maturity). Types of yield curves:

Useful definitions

Expectations hypothesis

Liquidity preference theory

Market segmentation theory

Preferred habitat theory Denies macroeconomic fundamentals of forward premium definition. It’s assumed that investor is not a professional, he has his own horizon of investment and prefers to buy bonds not outside its limits. Market term structure of yield securities is the result of agents independent decision makings. There are own demand and supply in every such “habitat” that leads to any sign and change in forward premium. Only bonds with close terms to maturity could be considered as substitutes and could have the same forward premium.

Empirical estimation of term structure hypotheses weak empirical support for the expectations hypothesis ARCH, GARCH, Engle 1982, Bollerslev 1986, Engle, Ng, Rotshild, 1990: introduction to the model conditional dispersion of forecast errors presenting strong fluctuations of time-series forward rates. Non-stationarity, unit-root testing of time series of yields with different terms to maturity Cointegration of time-series: long-term relationship between the rates of different terms, while their short-term fluctuations could be considered as “random walk” Efcectiveness of the hypothesis of term structure: analysis of the possibikity of interest rates with different terms of maturity to forecast future inflation changes, i.e. Fisher hypothesis testing about the term structure. Estimation of variant in time forward premium

Conclusions We’ve learned the main hypotheses explaining the term structure of interest rates We covered approaches to empirical estimation of interest rates hypotheses

References Brooks C. Introductory Econometrics for Finance. Cambridge University Press Cuthbertson K., Nitzsche D. Quantitative Financial Economics. Wiley Tsay R.S. Analysis of Financial Time Series, Wiley, Y. Ait-Sahalia, L. P. Hansen. Handbook of Financial Econometrics: Tools and Techniques. Vol. 1, 1st Edition Alexander C. Market Models: A Guide to Financial Data Analysis. Wiley Cameron A. and Trivedi P.. Microeconometrics. Methods and Applications Lai T. L., Xing H. Statistical Models and Methods for Financial Markets. Springer Poon S-H. A practical guide for forecasting financial market volatility. Wiley, Rachev S.T. et al. Financial Econometrics: From Basics to Advanced Modeling Techniques, Wiley, 2007.