The Role of Expectations in Interest Rate Determination

The purpose of this paper is to understand the role of expectations in the determination of interest rates in the Philippines. The study focused on the interest rates of Philippine Treasury Bills from 1970 to 1980. The results show that the market makes forecast of the future levels of interest rates and that the market participants revise these expectations in a manner consistent with the error-learning behavior. The changes in expectations as measured by the forward rates are a positive function of the forecasting errors, However, the forward rates are biased estimates of future rates, due to the presence of a liquidity premium on longer-term maturities. This makes the Treasury bills of varying maturities of varying maturities non-substitutable with each other.