A Unified Theory of Underreaction, Momentum Trading and Overreaction in Asset Markets
We assume that the instantaneous riskless rate reverts towards tendency which in turn, is changing stochastically over time. As result, current rates are not sufficient to predict future rates movements, as would be the case if the central tendency was constant. However, since longer-maturity bond prices incorporate information about the tendency, longer-maturity bond yields can be used to predict future short-term rate movements. We develop two-factor model of the term-structure which implies that a linear combination of any two rates can be used as proxy for the tendency. Based on this central-tendency proxy, we estimate model of the one-month rate which performs better than models which assume the tendency to be constant.