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Wednesday, October 26, 2011

Is Pure Expectations Hypothesis useful?

Does Pure Expectations Hypothesis provide good estimates of future rates?

Does PEH matter?

Most finance students at one point or another have the Pure Expectations Hypothesis. The professor will show term structure data, and then say something like…

“If PEH holds (big if) we can use today’s data to calculate what the market expectations are for next year’s rates. “

How good are these predictions?

Based on 2010’s daily term structure data, I calculated the PEH expectations for 2011. Take a look for yourself. The chart below shows the prediction and the real outcome.

Will they come closer?

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