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Issue Date: 1992
Abstract: The term structure of interest rates is an important research topic for one to understand the rational behaviour of investors in the fixed-income securities market. The relationship between long-term and short-term interest rates is crucial for macroeconomic policy evaluation. Unfortunately, the determinants of the term structure remain poorly understood. The Expectations and Liquidity Premium Hypotheses are two theories meant to explain the behaviour interest rates formation in an economy. Since Fisher's work on the theory of interest, many researchers have studied the term structure of interest rates in several countries. These include several studies on the American, Australian, British and the Japanese markets. These studies have been restricted to the Treasury markets as they are liquid and sizeable. They have found the Expectations and Liquidity Premium theories useful in understanding the yield curve even though evidence for full endorsement of the theories have not been found. There has been no study on this topic on the Singapore Treasury market. After the market revamp in May 1987, the Singapore Government securities market seemed to be gaining momentum and attracting investors' interest. There is a need to understand the behaviour of the term structure of the Singapore Government securities market. It is with this motivation that this Academic Exercise has been identified. This study attempts to achieve several objectives. Firstly, we want to investigate if the Expectations Hypothesis explains the term structure in Singapore. This will be done by examining if the forward rates are unbiased and efficient estimates of the future spot rates. Furthermore, we hope to test the Expectations Hypothesis by adopting Meiselman's Error-Learning Model. In the model, Expectations Hypothesis is supported if transactors revise their expectations of future rates whenever they find past expectations to be in error. Secondly, we want to test if the Liquidity Premium Theory provides better explanation for the term structure. This is done by including two variables (Volatility Index and Level of Interest Rates) as risk premia variables to explain interest rates. Lastly, with a better understanding of the term structure, an attempt is made to establish the relationship between the term structure and the future inflation rates. If expectations are really formed in the Treasury market, it is quite possible that the inflation expectations (as in the Inverted Fisher Hypothesis) holds. The findings of this study suggest that the Expectations Hypothesis is useful in explaining the behaviour of investors in the Singapore Treasury bills market though not to the same extent in the longer-term notes and bond markets. This is especially evident in the more active 3-month Treasury bills market, in the period after the market revamp in 1987. The two proxies (Volatility Index and Level of Interest Rates) can be measures of the risk premia. Generally, the term structure contains a time-varying risk premium. Thus, both the Expectations and Risk Premium Hypotheses appear to contribute to the understanding of the Treasury market in Singapore. The longer-term term structure does not appear to capture any information about future inflation rates. However, the shortest end (3 and 6 months) of the market appear to capture inflation expectations: this suggest that the base rate, on which other rates depend, incorporates inflation expectations. The 3-month Treasury bills is more actively traded and therefore more efficiently priced. Hence, this finding makes good sense. This, in aggregate appear not to contradict findings on the four hypotheses tested. The results of this academic exercise appear to explain the term structure of the Singapore Government securities using the Expectations and Liquidity Premium Theories. Both the theories have been found to be useful. This study has also found two variables (Volatility Index and Level of Interest Rates) that explain the risk premium in the term structure. Many studies have been done to establish the relationship between level of interest rates and the level of inflation rates. Information content of inflation expectations appear to be incorporated in the yield curve via the 3 and 6 month Treasury bills returns. Unlike in other studies to date, we tested the validity of model assumptions by examining (i) serial correlation and (ii) heteroscedasticity. Where these assumptions were violated, appropriate procedures were adopted for correcting the series so that the results are robust.
Appears in Collections:Bachelor's Theses

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