Skip to main content
SpringerLink
Log in

The Term Structure of Interest Rates in India

  • Chapter
  • First Online:
Monetary Policy in India

  • 848 Accesses

Abstract

We examine the term structure of interest rates in India to see if the yield curve can be rationalized based on the ‘expectations hypothesis.’ Although we find evidence of predictability for holding period returns, we reject the null hypothesis that the expectations hypothesis holds for the period under consideration. Contrary to the finding in the US, the volatility of Indian bond returns is consistent with the expectations hypothesis. Returns on long-term bonds are less volatile than those of short-term bonds. The volatility puzzle documented by Shiller on US data is not observed in Indian bond returns.

We thank Ravi Bansal, John Donaldson, an anonymous referee and the editors for their insightful comments and Neeru Mehra for editorial assistance. The usual caveat applies.

This is a preview of subscription content, log in via an institution to check access.

Access this chapter

Log in via an institution
Chapter
USD 29.95
Price excludes VAT (USA)
  • Available as PDF
  • Read on any device
  • Instant download
  • Own it forever
eBook
USD 169.00
Price excludes VAT (USA)
  • Available as EPUB and PDF
  • Read on any device
  • Instant download
  • Own it forever
Softcover Book
USD 219.99
Price excludes VAT (USA)
  • Compact, lightweight edition
  • Dispatched in 3 to 5 business days
  • Free shipping worldwide - see info
Hardcover Book
USD 219.99
Price excludes VAT (USA)
  • Durable hardcover edition
  • Dispatched in 3 to 5 business days
  • Free shipping worldwide - see info

Tax calculation will be finalised at checkout

Purchases are for personal use only

Institutional subscriptions

Notes

  1. 1.

    While there is a considerable literature documenting the correlation between economic growth and financial development, Rajan and Zingales (1998) provide convincing evidence on causality.

  2. 2.

    Indian equity markets had their inception in the early 1830s. The first organized exchange—the Native Share and Stock Brokers’ Association (the forerunner of the Bombay Stock Exchange) was established in 1887 making it the oldest in Asia. The market experienced its first crash in 1865. The run up in stock prices prior to the crash was a consequence of the increased demand for Indian cotton precipitated by the disruption of cotton supplies due to the American Civil War.

  3. 3.

    See Wells and Schou-Zibell (2008), Mohan and Ray (2009) for an excellent overview.

  4. 4.

    The Patil Committee report (2005) and the Rajan Committee report (2008).

  5. 5.

    Both the payoffs and the price are denominated in the numeraire consumption good.

  6. 6.

    Assets that have identical payoffs have identical prices.

  7. 7.

    See Ross (1976), Harrison and Kreps (1979), Hansen and Richards (1987) for the technical restrictions on the payoff process for Eq. (1) to hold.

  8. 8.

    \( m_{s + t,t} = \prod\limits_{k = 0}^{s - t - 1} {m_{t + k + 1,t + k} } \), where \( m_{t + k + 1,t + k} \) is a random variable such that \( P_{t + k} = E[m_{t + k + 1,t + k} \,y_{t + k + 1} |\Phi _{t + k} ] \).

  9. 9.

    A securities market is arbitrage-free if no security is a "free lottery" and any portfolio of securities with a zero payoff has zero price.

  10. 10.

    If markets are incomplete, there will, in general, be multiple processes \( \{ m_{s + t,t} \}_{s = 1}^{\infty } \) such that (1) holds. Not all of them need have a strictly positive support.

  11. 11.

    Households maximize utility given their endowments and security prices and supply equals demand at these security prices.

  12. 12.

    Our definitions below draw on Campbell et al. (1997).

  13. 13.

    In the US, Treasury Inflation Protected Securities (TIPS) debuted in 1997 and research on the real term structure is still in its infancy. See Pflueger and Viceira (2013). India briefly issued inflation indexed bonds in 1997 and again starting in 2013.

  14. 14.

    This is what is commonly done in practice.

  15. 15.

    Backus et al. (1998) provide an excellent introduction to this literature.

  16. 16.

    If bond returns are log normally distributed, it can be shown that the maximum "error" introduced by using one version instead of the other is bounded by \( 2 \times (2^{ - 1} \sigma^{2} ) \); since the standard deviation \( \sigma \) of bond returns is typically a few percentage points, the quantitative effect is small. Technically, the error arises due to Jensen’s inequality (\( E\,\ln (x){ \ne }\ln \,E(x) \) and \( E(1/x) \ne 1/E(x) \)).

  17. 17.

    Campbell et al. (1997) introduce yet another variation on the expectations hypothesis, the "pure expectations hypothesis." This is simply Eq. (12) with \( \theta_{s} = 0 \). We do not use this interpretation here.

  18. 18.

    This extension makes the fitted yield curve more flexible.

  19. 19.

    The estimates for this nominal curve are updated daily, and are available from January 1972 on the Federal Reserve Board website.

  20. 20.

    The prices are weighted by the inverse of the duration of the securities. Underlying Treasury security prices in the Gürkaynak, Sack, and Wright estimation are obtained from CRSP (for prices from 1961–1987), and from the Federal Reserve Bank of New York after 1987.

  21. 21.

    For an application of this methodology to other countries see, for example, Jondeau and Ricart (1999).

  22. 22.

    The yield curve is updated daily.

  23. 23.

    Campbell and Shiller (1991) refer to the spread between the current s- and one-period yields as the "perfect foresight" spread.

  24. 24.

    One of the concerns with the Campbell-Shiller regression is that the long yield \( y_{s,t} \) appears on both sides of the regression. Thus, the negative sign may be a result of measurement error. To deal with this, Campbell and Shiller (1991) test the robustness of their results using instrument variables for the long yields.

  25. 25.

    In addition, under the pure expectations hypothesis the intercept term should be zero.

  26. 26.

    For bonds with duration less than 2 years, in many instances we cannot reject the expectations hypothesis. This is in contrast to the observations in the US.

  27. 27.

    As evidenced by the slope coefficients of the Campbell-Shiller regression being different from 1.

  28. 28.

    As noted by Campbell (1995), going long in bond holdings during periods in which the yield curve is steep, and shorting in periods of a flat yield curve is an investment strategy that has, historically, produced higher than average returns.

  29. 29.

    The long rates are derived using the expectations hypothesis.

  30. 30.

    The authors use the term premia to explain the rejections of the expectations hypothesis.

  31. 31.

    In the Indian context, however, the real term structure of interest rates is not available as inflation indexed bonds have only been recently introduced. Hence expectations about future inflation cannot be inferred from the term structure.

  32. 32.

    Source: RBI’s Handbook of Statistics on the Indian Economy.

  33. 33.

    Since we are using monthly data, there are several qualifications to our exercise. As noted by Gürkaynak et al. (2005), this regression may be subject to the simultaneous equation or omitted variables bias. For example, the change in the RBI’s policy rate may be a response of the rate to the change in asset prices that took place in the previous month. That is, the change in the policy rate is not a surprise. Analysis of the change in daily yields in response to surprise changes in the repo rate is a promising topic for future research.

  34. 34.

    It is possible that the mapping from real short-term to real long-term rates is stable but the risk premium for inflation is time varying.

References

  • Ang, A., Bekaret, G., & Wei, M. (2008). The term structure of real rates and expected inflation. Journal of Finance, 63(2), 797–849.

    Article  Google Scholar 

  • Backus, D. K., Foresi, S., & Telmer, C. (1998). Discrete-time models of asset pricing. NBER Working paper 6736.

    Google Scholar 

  • Bansal, R., & Shaliastovich, I. (2012a). A long-run risks explanation of predictability puzzles in bond and currency markets. Review of Financial Studies, 26, 1–33.

    Article  Google Scholar 

  • Backus, D. K., Gregory, A. W., & Zin, S. E. (1989). Risk premiums in the term structure: evidence from artificial economies. Journal of Monetary Economics, 24, 371–399.

    Article  Google Scholar 

  • Bansal, R., & Shaliastovich, I. (2012). A long-run risks explanation of predictability puzzles in bond and currency markets. Working Paper.

    Google Scholar 

  • Bekaert, G., & Hodrick, R. J. (2001). Expectations hypotheses tests. Journal of Finance, 56, 1357–1394.

    Article  Google Scholar 

  • Campbell, J. Y. (1995). Some lessons from the yield curve. Journal of Economic Perspectives, 9(3), 129–152.

    Article  Google Scholar 

  • Campbell, J. Y., & Shiller, R. J. (1991). Yield spreads and interest rate movements: A bird’s eye view. Review of Economic Studies, 58, 495–514.

    Article  Google Scholar 

  • Campbell, J. Y., Lo, A. W., & Craig MacKinlay, A. (1997). The econometrics of financial markets. Princeton University Press.

    Google Scholar 

  • Cox, J. C., Ingersoll, J. E. and Ross, S. A. (1981). A re-examination of traditional hypotheses about the term structure of interest rates, Journal of Finance, 36(4), 769–799.

    Google Scholar 

  • Darbha, G., Roy, S. D. & Pawaskar, V. (2000). Estimating the zero-coupon yield curve. Working paper, National Stock Exchange.

    Google Scholar 

  • Dai, Q., & Singleton, K. J. (2002). Expectation puzzles, time-varying risk premia, and affine models of the term structure. Journal of Financial Economics, 63(3), 415–441.

    Article  Google Scholar 

  • Donaldson, J. B., Danthine, J.-P., & Mehra, R. (1992). The equity premium and the allocation of income risk. Journal of Economic Dynamics and Control, 16, 509–532.

    Article  Google Scholar 

  • Dybvig, P. H. & Ross, S. A. (2008). Arbitrage. In The new Palgrave dictionary of economics (2nd ed.).

    Google Scholar 

  • Fama, E. F., & Bliss, R. R. (1987). The information in long-maturity forward rates. American Economic Review, 77(4), 680–692.

    Google Scholar 

  • Froot, K. (1989). New hope for the expectations hypothesis of the term structure of interest rates. Journal of Finance, 44, 283–305.

    Article  Google Scholar 

  • Fuhrer, J. (1996). Monetary policy shifts and long-term interest rates. The Quarterly Journal of Economics, 111(4), 1183–1209.

    Article  Google Scholar 

  • Gandhi, R. (2015). Corporate Debt Market: What needs to be done—a reaffirmation. Inaugural address, CARE Ratings Debt Market Summit, Mumbai.

    Google Scholar 

  • Gürkaynak, R., Sack, B., & Wright, Jonathan. (2007). The U.S. treasury yield curve: 1961 to the present. Journal of Monetary Economics, 54(8), 2291–2304.

    Article  Google Scholar 

  • Gürkaynak, R., Sack, B., & Swanson, E. T. (2005). Do actions speak louder than words? The response of asset prices to monetary policy actions and statements. International Journal of Central Banking, 1, 55–93.

    Google Scholar 

  • Hansen, L. P., & Richard, S. P. (1987). The role of conditioning information in deducing testable restrictions implied by dynamic asset pricing models. Econometrica, 55(3), 587–613.

    Article  Google Scholar 

  • Haubrich, J., Pennacchi, G., & Ritchken, P. (2012). Inflation expectations, real rates, and risk premia: Evidence from inflation swaps. Review of Financial Studies, 25, 1588–1629.

    Article  Google Scholar 

  • Harrison, J. M., & Kreps, D. M. (1979). Martingales and arbitrage in multiperiod securities markets. Journal of Economic Theory, 20, 381–408.

    Article  Google Scholar 

  • Hutchison, M., Sengupta, R., & Singh, N. (2013). Dove or Hawk? Characterizing Monetary Policy Regime Switches in India. Emerging Market Review.

    Google Scholar 

  • Jondeau, E., & Ricart, R. (1999). The expectations hypothesis of the term structure: tests on US, German, French, and UK Euro-rates. Journal of International Money and Finance, 18, 725–750.

    Article  Google Scholar 

  • Kozicki, S., & Tinsley, P. A. (2001). Shifting endpoints in the term structure of interest rates. Journal of Monetary Economics, 47(3), 613–652.

    Article  Google Scholar 

  • Kozicki, S., & Tinsley, P. A. (2005). What do you expect? Imperfect policy credibility and tests of the expectations hypothesis. Journal of Monetary Economics, 52(2), 421–447.

    Article  Google Scholar 

  • Mankiw, N. G., & Summers, L. H. (1984). Do long-term interest rates over-react to short-term interest rates? Brookings Papers on Economics Activity, Economic Studies Program, The Brookings Institution, 15, 223–248.

    Article  Google Scholar 

  • McCulloch, J. H. (1990). U.S. government term structure data. In B. Friedman & F. Hahn (Eds.), The Handbook of Monetary Economics. Amsterdam: North Holland.

    Google Scholar 

  • Mohan, R., & Ray, P. (2009). Development of the Indian Debt Market. Stanford Center for International Development, Working paper no. 410.

    Google Scholar 

  • Nelson, C. R., & Siegel, A. F. (1987). Parsimonious modeling of yield curves. Journal of Business, 60, 473–489.

    Article  Google Scholar 

  • Nimark, K. P. (2012). Speculative dynamics in the term structure of interest rates. Working paper.

    Google Scholar 

  • Piazzesi, M., Salomao, J., & Schneider, M. (2015). Trend and cycle in bond premia. Working paper. Stanford University.

    Google Scholar 

  • Pflueger, C. E., & Viceira, L. M. (2013). Return predictability in the treasury market: real rates, inflation, and liquidity. Working paper, Harvard University.

    Google Scholar 

  • Rajan, R. G. and Zingales, L. (1998). Financial Dependence and Growth, American Economic Review, 88(3), 559–586.

    Google Scholar 

  • Ross, S. A. (1976). The arbitrage theory of capital asset pricing. Journal of Economic Theory, 13(3), 341–360.

    Article  Google Scholar 

  • Schou-Zibell, L. and Wells, S. (2008). India’s bond market—developments and challenges ahead, ADB Regional Economic Integration Working Paper No. 22

    Google Scholar 

  • Sinha, A. (2016). Learning and the yield curve. Journal of Money, Credit and Banking, 48(2–3), 513–547.

    Google Scholar 

  • Svensson, L. E. O. (1994). Estimating and interpreting forward rates: Sweden 1992-4. National Bureau of Economic Research Working Paper 4871.

    Google Scholar 

  • Vasicek, O. (1977). An equilibrium characterization of the term structure. Journal of Financial Economics, 5, 177–188.

    Article  Google Scholar 

  • Wachter, J. A. (2006). A consumption-based model of the term structure of interest rates. Journal of Financial Economics, 79, 365–399.

    Article  Google Scholar 

Download references

Author information

Authors and Affiliations

  1. Arizona State University, Tempe, AZ, USA

    Rajnish Mehra

  2. NBER, Cambridge, MA, USA

    Rajnish Mehra

  3. NCAER, New Delhi, India

    Rajnish Mehra

  4. Luxembourg School of Finance, Luxembourg, Luxembourg

    Rajnish Mehra

  5. Fordham University, New York, USA

    Arunima Sinha

Authors
  1. Rajnish Mehra
    View author publications

    You can also search for this author in PubMed Google Scholar

  2. Arunima Sinha
    View author publications

    You can also search for this author in PubMed Google Scholar

Corresponding author

Correspondence to Rajnish Mehra .

Editor information

Editors and Affiliations

  1. Economics and Planning Unit, Indian Statistical Institute, New Delhi, India

    Chetan Ghate

  2. Department of Economics, University of California, Santa Cruz, California, USA

    Kenneth M. Kletzer

Appendix

Appendix

Data Sources

Statistic

Source

Total Internal Marketable Debt

Outstanding central government debt from: Handbook of Statistics on Central Government Debt

Gross Fiscal Deficit and its Financing

Handbook of Statistics on the Indian Economy, 2013–14 (Table 105). RBI publication

GDP at Market Prices

Handbook of Statistics on the Indian Economy, various editions. RBI publication

Ownership patterns of GoI Securities

Handbook of Statistics on Central Government Debt

Rights and permissions

Reprints and permissions

Copyright information

© 2016 Springer India

About this chapter

Cite this chapter

Mehra, R., Sinha, A. (2016). The Term Structure of Interest Rates in India. In: Ghate, C., Kletzer, K. (eds) Monetary Policy in India. Springer, New Delhi. https://doi.org/10.1007/978-81-322-2840-0_8

Download citation

  • DOI: https://doi.org/10.1007/978-81-322-2840-0_8

  • Published:

  • Publisher Name: Springer, New Delhi

  • Print ISBN: 978-81-322-2838-7

  • Online ISBN: 978-81-322-2840-0

  • eBook Packages: Economics and FinanceEconomics and Finance (R0)

Publish with us

Policies and ethics

Search

Navigation