Peso Problem Explanations for Term Structure Anomalies

The authors examine the empirical evidence on the expectations hypothesis of the term structure of interest rates in the United States, the United Kingdom and Germany using the Campbell-Shiller (1991) regressions and a vector-autoregressive methodology. They argue that anomalies in the U.S. term structure, documented by Campbell and Shiller (1991), may be due to a generalized peso problem in which a high-interest rate regime occurred less frequently in the sample of U.S. data than was rationally anticipated. They formalize this idea as a regime-switching model of short-term interest rates estimated with data from seven countries. Technically, this model extends recent research on regime-switching models with state-dependent transitions to a cross-sectional setting. Use of the small sample distributions generated by the regime-switching model for inference considerably weakens the evidence against the expectations hypothesis, but it remains somewhat implausible that their data generating process produced the U.S. data. However, a model that combines moderate time-variation in term premiums with peso-problem effects is largely consistent with term-structure data from the U.S., UK and Germany.