A study of interest rates with an empirical test using data from the United Arab Emirates

Abstract

The purpose of this study is to perform an empirical analysis of the term structure of interest rates in the United Arab Emirates (UAE). The analysis will focus on the relationship between forward interest rates and the corresponding future spot rates. The main hypothesis to be tested is that forward rates, as posited by the pure expectation hypothesis (PEH, John Hicks (1939)), are unbiased estimators of future spot rates.

Chapter I discusses the importance of the term structure of interest rates and why it is essential to be able to forecast the future spot rates using the information contained in the current spot rates.

Chapter II illustrates the functions of the interest rates in the economy and discusses the theories of interest rates, inflation, yield curve and the term structure of interest rates, duration and factors affecting interest rates.

Chapter II describes the Dubai Financial Market (DFM), its trading and settlement process and top securities traded on the DFM in 2002.

Chapter IV undertakes the hypothesis development and the analysis of the data. Using historical data, the forward rates as predictors of future spot rates are calculated and the results are compared with the actual future spot rates. This chapter is then followed by a summary of the findings and the limitations of the study. According to the estimations and computations, it was found that the expected future spot rates computed with the aid of the pure expectations hypothesis (PEH), are good predictors of the actual future spot rates, given the fact that the level of confidence of the test was set to be 98%.

Although a large data set, compiled over short intervals during the period January 1992 and July 2003 was used, the data had some limitations. One of the main limitations was the incompleteness of the data set during the period of the study. The actual 2,4,5,7,8,10 and 11-month inter-bank interest rates were missing; therefore, even if the expected future spot rates were computed, some actual rates needed for the comparison were unavailable.

In addition, the one-month spot interest rates, which were used for the estimation of the three-month forward interest rates, were not announced on the first day of each month; as a result, some months were shorter that the others.

Finally, such studies are expected to give more reliable results if a larger sample size is used, such as 20 years or more.