An experimental investigation of the term structure of interest rates
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An experimental investigation of the term structure of interest rates James Watson School of Economics, University of East Anglia
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An experimental investigation of the term structure of interest rates. James Watson School of Economics, University of East Anglia. An experimental investigation of the term structure of interest rates. Introduction The term structure of interest rates Macroeconomic experiments - PowerPoint PPT Presentation
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An experimental investigation of the term structure of interest rates
James WatsonSchool of Economics, University of East Anglia
An experimental investigation of the term structure of interest rates
Introduction The term structure of interest rates Macroeconomic experiments Experimental design Experimental results Conclusions
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Introduction
Policymakers set short term nominal interest rates
Main instrument of modern monetary policy
Long term interest rates are anchored to the return on long term government bonds
Private sector investment, personal mortgages and refinancing government debt depend on longer term interest rates
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Introduction
The price of government bonds is determined by the market
Policymakers control the short rate but want to control the long rate
Understanding the link between the two is crucial for policy
This is the term structure of interest rates4
The term structure of interest rates
The yield on a government bond is the annualised return to maturity
A 2-year UK treasury bond matures for £100
If you were to buy one for £90.70 you are guaranteed a 5% return (or yield) on your investment (unless UK plc goes bust of course!
7090051100
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£
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The term structure of interest rates
If you thought a certain 5% return on your money over the next two years was good (!) you would buy these bonds – as would everybody else…
Clearly demand is driven by the certain return you might expect to get elsewhere
The term structure of interest rates (or yield curve) is the line connecting yields of differing maturities. Long interest rates are anchored to the term structure 6
The term structure of interest rates
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The upward slope suggests an expectation that interest rates will increase
This is the expectations hypothesis of the term structure An upward slope is also thought to represent a risk averse attitude to the future – a premium for holding a risky asset
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yiel
d (%
)
0 3 6 9 12 15 18 21 24maturity (years)
UK term structure 10th June 2010
The term structure of interest rates
The expectations hypothesis says:
The short interest rate should predict the long interest rate up to some risk premium
For an excellent review of theory, testing and some empirical results see Cuthbertson & Nitzche (2004)
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premium risk t] period for rate short[the t] period for bond a holding for return[E
The term structure of interest rates Could a clear policy objective flatten the term
structure?
Does it help if the policymaker is trustworthy?
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UK inflation target 1992-
Formal BoE independence 1997-
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1015
yiel
d (%
)
1970
1975
1980
1985
1990
1995
2000
2005
2010
year
UK 10 year nominal treasury bond yields
The term structure of interest rates
Mixed results: the term structure must be governed by arbitrage plus risk. This has proved difficult to observe empirically…
Time-varying risk, monetary policy regime, global economic shocks, cross-country variation, causality, non-stationarity of data
For a review see Campbell (1995) and Kozicki and Tinsley (2001)
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Macroeconomic experiments The laboratory can control for these
confounds
Test a theory in the laboratory
Does the laboratory approximate the real world?
Testing policy: it’s difficult to experiment on the real economy
For surveys see Duffy (2008), Ricciuti (2005)11
Experimental design
Does a trustworthy policymaker have more control over the term structure?
Does it matter if signals about the future are more (or less) accurate?
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Experimental design 5 subjects participate in a simple 2-period economy
Buy and/or sell bonds to alter the ratio of cash to bonds held via an interactive computerised auction programmed in z-Tree
Value of cash is certain, value of bonds depends on the future state of the world – this implies a 2-period term structure
Subjects participate in 15 independent rounds and are paid according to their performance in one randomly selected round
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Experimental design
Two policymakers:
Inflation targeter: trustworthy, expect high inflation get high interest rates
Second policymaker cares about inflation and output: policy response is more uncertain
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Experimental design Subjects receive signals about future output &
future inflation
Subjects face one policymaker with either low noise or high noise signals
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Low risk High riskInflation targeter A2 A4
Policy uncertainty B2 B4
4 treatments
2-by-2 design
Experimental design
Subjects receive information about their policymaker type
Statement of intent:
To deliver stable inflation To deliver a steady increase in production and
deliver stable inflation
Examples of previous policy decisions16
Experimental design
Predictions:
Increasing policy uncertainty increases the risk premium
Increasing risk increases the risk premium
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Experimental results Is testing the term structure in the laboratory
viable?
Subjects seemed to understand the environment. In all treatments except B4 the term structure contains statistically significant information about the path of the short interest rate
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Low risk High riskInflation targeter A2 A4
Policy uncertainty B2 B4
The expectations hypothesis does significantly better with an inflation targeter than with policy uncertainty
Experimental results
Between treatment differences are not as predicted
No statistically significant difference between risk premia
The difference is in the informational content of the term structure
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Low risk High riskInflation targeter A2 A4
Policy uncertainty B2 B4
The ‘A’ policymaker has more control over the term structure
Experimental results
Subjects make significant use of the previous rounds trade prices in all 4 treatments
As policy uncertainty increase subjects rely more on the past
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Low risk High riskInflation targeter A2 A4
Policy uncertainty B2 B4
In treatment ‘B4’ subjects make no significant use of signals about the future
Experimental results
Statistically significant differences between policymakers
More risk leads to a significant change in behaviour
The effects are direction theoretically predicted, but empirically are unexpected
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Conclusions Overall positive from the perspective of testing
the term structure in the laboratory
Policy uncertainty leads to less control of the term structure or conversely, the term structure is less useful as a predictor of the short rate
Evidence that increased policy uncertainty significantly changes behaviour, but not in the way theory predicts
A possible insight into why the empirical results are mixed
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Appendix: Expectations hypothesis More trade in uncertain ‘B’ treatments.
Wilcoxon tests: p-values < 0.01
Expectation Hypotheses:
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structureterm of Sloperate shortin Change 21
Treatment Slope (ß) p-valueSig greater then (Chow test)
A2 0.395 0.000 >A4*,B2**,B4***
A4 0.260 0.000 >B4*B2 0.166 0.068 >B4*B4 0.007 0.619Results from multi-level restricted maximum likelihood regression
*,**,*** indicate significance at 10%, 5% and 1% levels respectively
Appendix: Adaptive expectations
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tradesyRR sigsigrr 43211
What does the long rate depend on?
Treatment
β1 β2 β3 β4
A2 0.233*** 0.476*** -0.010 0.079***A4 0.572*** 0.351*** -0.131 0.119***B2 0.393*** 0.264*** -0.033 0.119***B4 0.551*** 0.180 0.087 0.018
Results from multi-level restricted maximum likelihood regression*,**,*** indicate significance at 10%, 5% and 1% levels respectively
Appendix: Experimental term structures
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05
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2025
Yie
ld (%
)
1 2time
Treatment A2
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2025
Yie
ld (%
)
1 2time
Treatment A4
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1015
2025
Yie
ld (%
)
1 2time
Treatment B2
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2025
Yie
ld (%
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1 2time
Treatment B4
Appendix: Policy rule and noise Policy via Taylor Rule
Treatment ‘A’: ρ = 1 Treatment ‘B’: ρ = 0.5
Treatment ‘2’: Noise ~ N[0,4] Treatment ‘4’: Noise ~ N[0,16]
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*t
*t
*t yy..ii 15151
ReferencesCampbell, John Y. 1995. “Some lessons from the yield curve.”, Journal of
Economic Perspectives, 9: 129-152
Cuthbertson, Keith, and Dirk Nitzche. 2004. Quantitative Financial Economics. Wiley
Duffy, John. 2008. “Macroeconomics: A Survey of Laboratory Research.” Working Paper 334, University of Pittsburgh, Dept. of Economics, downloadable at http://www.econ.pitt.edu/papers/John_hee11.pdf
Fischbacher, Urs. 2007. “z-Tree: Zurich toolbox for ready made economic experiments.” Experimental Economics, 10: 171-178
Kozicki, Sharon, and Peter Tinley. 2001. “Shifting endpoints in the term structure of interest rates.” Journal of Monetary Economics, 47: 613-652
Ricciuti, Roberto. 2008. “Bringing macroeconomics into the lab.” Journal of Macroeconomics, Elselvier, 30(1): 216-237
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