Testing a Model of the Term Structure of Interest Rates by Simulation of Market Forecasts

This article is concerned with testing a model of the term structure of interest rates. The model relates the term premiums embodied in forward rates to the level of interest rates and an index of business confidence. Theoretical considerations suggest that the latter variables are inversely related to term premiums. Empirical implementation focuses on the use of optimal forecasts of spot rates implied by time series models as simulated values of market forecasts. Tests of the model using the Durand data for 1900–1958 indicate the presence of the inverse relationships suggested.