Finance Theory I

Finance theory provides some specific guidance when forming forecasts of future interest rates. Nonetheless, important questions remain open. The Holy Grail of this literature is a dynamic model that is parsimonious owing to economically-motivated restrictions. The requirement of no-arbitrage is motivated by economics, but by itself it is too weak to matter. Economic restrictions with bite require, either directly or indirectly, that risk premia dynamics be tied down by economic principles. There no consensus in the literature about how this should be done. To date, no restrictions that come out of our workhorse models of asset pricing appear to be consistent with the observed behavior of Treasury bond yields.

Another open question is whether any variables contain information about future interest rates that is not already in the current term structure. Recent empirical work suggests that both lagged bond yields and certain macroeconomic variables have incremental information, but this chapter argues that the robustness of these results is not yet known. A closely related question is whether changes in the overall level of the term structure are forecastable. Again, recent empirical work suggests (at least implicitly) they are forecastable, but the nature of this forecastability raises some statistical and economic problems that are not yet resolved.