Three Essays on the Term Structure of Eurocurrency Rates.

This dissertation investigates the term structure relationship in financial markets by using Eurocurrency rates of several countries. The first essay tests the restrictions of the expectations hypothesis of term structure and the Fisher hypothesis in an interrelated fashion to characterize the changes in the slope and the level of Eurocurrency yield curves of numerous countries. It is argued that the Fisher relation explains the level of the yield curve and the expectations hypothesis determines the long run relationship between yields at different maturities at that level. Special emphasis is given to the information content of the yield curve for future inflation. A factor decomposition technique is used to extract the common trend driving the yield curve and it is found that this common tread contains information about the long-run behavior of the inflation rate for each country in the sample. This finding is consistent with the argument that rational agents in the market incorporate the predictable portion of the expected inflation into interest rates while setting prices. The second essay focuses on convergence of international money market term structures. According to the covered interest parity theorem, nominal yield curves should converge in the long run. The common factor driving each term structure is extracted to test for long run linkages and transitory components are used to test for short run linkages. The findings indicate that an international convergence has not occurred although the term structures of countries that are a member of the exchange rate mechanism of the European Union have a stable long run relationship. This finding is explained as a result of the adjustable fixed exchange rate system employed. The essay also tests for and rejects the German European Union dominance hypothesis. The third essay tests for the restrictions of the rational expectations/constant term premium hypothesis of term structure. It is discussed that the commonly used single-equation regression test of the hypothesis is biased in small samples. The short rate is decomposed into its permanent and transitory components to test the theory in an unbiased regression. The results support the rational expectations theory