The Forward Premium of Euro Interest Rates

Sónia Costa and Ana Galvão

Working Papers from Banco de Portugal, Economics and Research Department

Abstract: We show that euro forward rates are biased predictors of future interest rates. A small part of this bias arises from unexpected changes in interest rates, while a larger part is explained by the forward premia, which are generally not time-varying. We estimate the the 3-month forward premia for different horizons using forecasts of yields obtained with the Diebold and Li (2006) approach, extended by the inclusion of macroeconomic variables. Confidence intervals for the estimates are computed using a novel bootstrap approach. When using German data for the period before 1999, we detect a break in the dynamic correlation between yield factors, implying that estimates of the euro forward premium using pre-euro data are biased. Although the forward premia of horizons up to 36 months are on average positive, their confidence intervals indicate that they are significantly equal to zero in some periods of time. They are also positively correlated with the ECB policy rate and with a measure of the market perception that future interest rates could be higher than expected.

JEL-codes: C32 E43 (search for similar items in EconPapers)
Date: 2007
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Persistent link: https://EconPapers.repec.org/RePEc:ptu:wpaper:w200702

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