Do forecast errors or term premia really make the difference between long and short rates?

Abstract

Forward rates in the term structure of interest contain predictions of future spot rates plus (possibly) term premia. Realized spot rates contain predicted spot rates plus forecast errors. Under rational expectations forecast errors are not predictable. By forecasting spot rates using publicly available information, bounds on the variation of forecast errors, and term premia are obtained. For one-month treasury bill rates, one to two thirds of the variation in the difference between forward rates and realized spot rates is due to variation in term premia.

The author thanks G. William Schwert and an anonymous referee for both substantive and expositional suggestions.

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