A COINTEGRATION ANALYSIS OF MALAYSIAN TERM STRUCTURE

Abstract

This paper demonstrates the existence of cointegrating relationships between the Malaysian short and medium interest rates (interbank rates), namely one-week, two-month, six-month and twelve-month rates, with the spread defining the cointegrating vectors, particularly by using the ‘pre-crisis’ sample period. Using this sample period, the Johansen approach is applied and results of the test imply that the spreads between interest rates form a basis for cointegration space. It is found that two error correction models, which use spreads as the error correction terms, are stable over this ‘pre-crisis’ sample period. They pass most of the diagnostic tests and it is also found that a non-linear structure existed in one of the models. The result is strengthened with the tests of stability which confirm that there is no structural change between the sample periods. The results of cointegration and error correction analyses also support the validity of the expectation hypothesis. For the long-run, the longer-term interest rates are playing a greater role as equilibrium attractors and this supports the long-to-short version of the expectation hypothesis. Similarly, in the short-run, causal impact runs from long- to short-term interest rates and further confirms the hypothesis.

JEL classification: C32, E43.

Key words: Term structure, Expectation hypothesis, Cointegration