ON RISK, RATIONALITY AND THE PREDICTIVE ABILITY OF EUROPEAN SHORT-TERM ADJUSTED YIELD SPREADS

In this paper, a rolling vector error correction model (VECM) is propo sed to construct measures of the market's time-varying conditional exp ectations of the 3-month money rates starting 13 weeks hence for sever al major EMS member countries. VECM-based predictions provide the basi s for computing ex-ante out-of-sample estimates of the term premia. Th ese term premia are then used to adjust the yield spreads as a prelude to investigating their ability to predict future interest rates. The source(s) of the yield spread bias are discussed. While the expectatio ns hypothesis is resoundingly rejected using the standard test specifi cation, yield spreads adjusted for time-varying term premia are found to possess substantial predictive ability and, in many instances, the expectations hypothesis is not rejected. The robustness of the results across the different European money markets and sample periods is hig hly encouraging. The test results underscore the importance of incorpo rating into the test specification the equilibrium cointegrating const raints if they exist. (C) 1997 Elsevier Science Ltd.