Endogenous term premia and anomalies in the term structure of interest rates: Explaining the predictability smile

Numerous studies have documented a 'predictability smile' in the post-war term structure of interest rates: spreads between long rates and short rates predict subsequent movements in short rates provided the long horizon is less than three months or greater than two years, but not for intermediate maturities. Proposed explanations of the smile involve interest rate smoothing by the Fed, time-varying risk premia,'Peso problems', and measurement error. We show that despite their highly restrictive nature, some parameterizations of the Cox-Ingersoll-Ross (CIR) and Chen-Scott (CS) models of the term structure can account for the predictability smile. CIR and CS parameterizations which are consistent with the smile regularity are inconsistent with other features of the data, however. (C) 1999 Elsevier Science B.V. All rights reserved.