BFS 2002 

Contributed Talk 
Andrew Carverhill
Distantly maturing forward rates represent the markets long term (risk neutral) expectations about interest rates. As such, they are the fundamental ingredient of the pricing kernel. In most equilibrium models, interest rates mean revert, and so long forward rates are asymptotically constant.
However, from US Treasury STRIPs data, forward rates slope increasingly downwards, and do not attenuate in volatility, as maturity increases beyond about 15 years. We model this in a equilibrium framework, by showing that most of the volatility in long forward rates is ``short term'', coming from a predictable, tightly mean reverting factor, but for which this mean reverting aspect is absent when we transform to risk neutral probabilities. We verify this predictable behavior in the STRIPs data, and also in T Bond futures data, where we can observe the risk neutral dynamic directly. It is striking that this short term behavior has such a large persistent effect on the forward rates.