Research Discussion Paper – RDP 8607 The Expectations Theory of the Term Structure and Short-Term Interest Rates in Australia
June 1986
Abstract
The expectations theory of the term structure of interest rates states that the yields on financial assets of different maturities are related primarily by market expectations of future yields. The expectations theory has occupied a prominent place in both theoretical and policy debates at various times. However, extensive empirical work in the United States has soundly rejected the joint (testable) hypothesis of the expectations theory and zero (or a constant) risk premium.
The aim of this paper is to test this joint hypothesis against Australian short-term interest rate data for the period since the introduction of the tender system for the sale of Treasury notes in 1979. The sample period chosen is interesting for a number of reasons. First, the market has had a greater influence on the determination of interest rates since the introduction of the tender system. Second, there was a major structural change in the Australian financial system with the floating of the Australian Dollar in 1983. This provides scope to test for the impact of policy or institutional changes on the expectations theory.
The paper finds that the joint hypothesis of the expectations theory and zero (or a constant risk premium), cannot be rejected in this period. Furthermore, this joint hypothesis cannot be rejected in the period before or after the introduction of the float. There is however, evidence of parameter instability across the pre- and post-float periods.