The Relationship between Short-Term and Forward Interest Rates: A Structural Time Series Analysis

In this paper, the structural time series approach is used to explain the relationship between short-term and forward U.S. interest rates and to decompose the rejection of the joint hypothesis of rational expectations and constant (or zero) expected term premiums, into systematic expectation errors and time-varying term premiums. The long run relationship between the two rates is examined by formulating a common trend or permanent component, while the transient effects of the relationship are explained by the transitory components in the model. Model estimates confirm many of the observed empirical characteristics in the term structure of U.S. interest rates and findings also reveal that both systematic expectation errors and time-varying premiums are important in explaining the rejection of the joint hypothesis.