Nonlinear mean reversion in the term structure of interest rates

Abstract

The expectations hypothesis implies that the yield curve provides information on the future change in the short-term interest rate. However, transaction costs exist in the financial market, which prevent investors from realizing the arbitrage opportunity, when the arbitrage does not fully cover the transaction costs. The purpose of this paper is to assess the effect of transaction costs on the predictability of the term structure by using the threshold vector error correction model, which allows for the nonlinear adjustment to the long-run equilibrium relationship. A significant amount of threshold effect is found, and the adjustment coefficients are regime-dependent. The empirical result supports the nonlinear mean reversion in the term structure of interest rates. (C) 2002 Elsevier Science B.V. All rights reserved.