An attractive theory of the term structure of interest rates is the expectations hypothesis, which holds that the long rate equals expected future short rates over the term of the bond. Many empirical studies, such as Shiller, Campbell, and Schoenholtz (1983), Fama (1984), Mankiw and Miron (1986), Fama and Bliss (1987), Mishkin (1988), Hardouvelis (1988), Froot (1989), Simon (1989, 1990), Cook and Hahn (1990), Campbell and Shiller (1991), and Roberds, Runkle and Whiteman (1996), find that the estimated coefficients in a regression of the change in the expected future short-term interest rates on the yield spread are significantly less than the value of unity predicted by the expectations hypothesis and differ as the forecast horizon varies. Even though Fama (1984), Mishkin (1988), Hardouvelis (1988), and Simon (1990) have found yield spreads do help predict future rates, the coefficient appears inconsistent with the expectations hypothesis.
Several studies, such as Mankiw and Miron (1986), McCallum (1994), and Rudebusch (1995), have shown that even if the expectations theory did hold, it would be hard to use it for forecasting due to interest rate smoothing by the Fed. Mankiw and Miron (1986) argue that the negligible predictive power of the spread after the founding of the Fed did not reflect a failure of the expectations theory. Instead, they suggest that the Fed ‘stabilized’ short-term rates, such as the three-month rate, and by inducing a random-walk behavior eliminated any predictable variation. McCallum (1994) proposes that the empirical failure of the rational expectations theory of the term structure of interest rates can be rationalized with the expectations theory by recognition of an exogenous random term premium plus the assumption that monetary policy involves smoothing of an interest rate instrument—the short-term rate—together with the responses to the prevailing level of the spread. Rudebusch (1995) states that Federal Reserve interest rate targeting accompanied by the maintained rational expectations hypothesis explains the varying predictive ability of the yield curve.
Previous studies have also focused on the possibility of a time-varying risk premium and concluded that a time-varying risk premium can help explain the failures of the expectations theory. Examples include Engle, Lilien and Robins (1987), Simon (1989, 1990), Friedman and Kuttner (1992) and Lee (1995), among others.
However, Evans and Lewis (1994) argue that a time-varying risk premium alone is not sufficient to explain the time-varying term premium in the Treasury bill. Dotsey and Otrok (1995) suggest that a deeper understanding of interest rate behavior will be produced by jointly taking into account the behavior of the monetary authority along with a more detailed understanding of what determines term premia.
Recently, Bansal and Coleman (1996) argue that some assets other than money play a special role in facilitating transactions, which affects the rate of return that they offer. In their model, securities that back checkable deposits provide a transaction service return in addition to their nominal return. Since short-term government bonds facilitate transactions by backing checkable deposits, this results in equilibrium in a lower nominal return for these bonds. Such a view implies that liquidity plays an important role in determining the returns of various securities..
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Another Look at Yield Spreads: The role of liquidity
