TIME VARYING RISK PREMIUM AND THE PREDICTIVE POWER OF THE AUSTRALIAN TERM STRUCTURE OF INTEREST RATES

Using weekly data on bank accepted bills over the 1976 to 1993 period, this paper provides direct evidence of the presence of a term premium in the Australian term structure. The term premium is shown to vary over time and have an adverse effect on the predictive power of the term structure. The variance of the expected term premium is quantified in terms of its lower bound relative to the upper bound of the variance of the rational expectations error. This ratio is observed to vary over sample sub periods and rise to a high of one in some periods which include the period immediately prior to the market crash.     

THE RISK STRUCTURE OF INTEREST RATES AND INTERDEPENDENT BORROWING COSTS: THE IMPACT OF MAJOR DEFAULTS

This paper develops a new methodology for evaluating the impact of economic events on bond yields. Term structure information and implicit forward rates are used to generate expected bond yields, and the difference between actual and expected yields is interpreted as the information effect of the event. The methodology is applied to two studies of municipal default: the New York City default and the more recent Washington Public Power Supply System (WPPSS) default. The analysis provides evidence that the New York City default did have a significant impact on the interest cost of municipal financing in general. In the case of WPPSS, however, there is no indication of a significant default impact.     

EXPONENTIAL DURATION: A MORE ACCURATE ESTIMATION OF INTEREST RATE RISK

We develop a new method to estimate the interest rate risk of an asset. This method is based on modified duration and is always more accurate than traditional estimation with modified duration. The estimates by this method are close to estimates using traditional duration plus convexity when interest rates decrease. If interest rates rise, investors will suffer larger value declines than predicted by traditional duration plus convexity estimate. The new method avoids this undesirable value overestimation and provides an estimate slightly below the true value. For risk‐averse investors, overestimation of value declines is more desirable and conservative.