Overreaction of yield spreads and movements of Brazilian interest ratest

Abstract

This paper tests the rational expectations hypothesis (REH) for Brazil from July 1996 to December 2001. For any pair of maturities between one day and one year, it shows that the yield spread between a longer-term and a shorterterm interest rate is an imprecise predictor of the short-term movements in the longer-term interest rate and of the long-term movements in the shorter-term interest rate. Moreover, yield spreads highly correlated with the rational expectations forecasts of future changes in the shorter-term rate, but significantly more volatile than these, suggest the rejection of the REB. The alternative hypothesis of overreaction of the yield spread to the expectation of future changes in the shorter-term rate seems a reasonable explanation to these findings, and can be rationalized by a monetary policy of interest rate smoothing.

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