Question

Question 2 The term structure of interest rates is the relationship between the yields on bonds of different maturities. Figure 2 below shows the 3 months, 6 months, 1 year, 3 year, 5 year and 10 year yields. 10 2 86 88 90 294 96 00 02 04 06 08 10 12 USTB 10Y USTB1Y USTB3M USTB3Y USTB5Y USTB6M Figure 2. USTBs for different maturities. a. Do you think the variables presented in Figure 2 are I(1) series? Explain your answer. [2 marks] b. Which test can be used to verify the expectations theory of the term structure. Explain how you could implement this test for the expectations theory using the 6 interest rates for US Treasury bonds of different maturities. [5 marks] c. You estimated the Error Correction Model for the 6 interest rates. What do disturbances from this model capture? [3 marks]d. The long-run parameter estimates of the VECM, B, has the following form: 1.000000 0.000000 0.000000 0.000000 0.000000 0.000000 1.000000 0.000000 0.000000 0.000000 0.000000 0.000000 1.000000 0.000000 0.000000 B = 0.000000 0.000000 0.000000 1.000000 0.000000 0.000000 0.000000 0.000000 0.000000 1.000000 -0.984151 -1.032363 -0.978260 -1.104874 -1.075952 (0.15466) (0.01984) (0.00836) (0.08520) (0.12167) [-6.36344] [-52.0387] [-117.004] [-12.9675] [-8.84352] Interpret the parameters and explain how these estimates are related to the expectations theory. [4 marks] e. Do you agree that a VECM allows to capture the short-run dynamics between the interest rates? Explain your answer. [4 marks] f. If a VECM with the different interest rates would have a zero rank, what model should we use? [2 marks] [Total of Question 2 = 20 marks]