Forward rates in the money market are systematically higher than realised spot rates, reflecting an unobservable term premium. This paper uses a Kalman filter specification to produce time‐varying estimates of the term premia in New Zealand and Australia. Three time series specifications are used to examine the properties of the premia, such as the average size, volatility, and the degree of mean reversion. Compared to the constant term premia estimates, the time‐varying estimates explain significantly more of the difference between forward and spot rates. The results suggest that the premium in New Zealand is slowly mean‐reverting, while the Australian premium reverts quickly to the mean. It is not clear whether the method of monetary policy implementation affects the term premium, although in New Zealand the premium has been smaller and less variable since the introduction of the Official Cash Rate in March 1999. A related finding is that the size of the term premium is correlated with the volatility of short‐term rates.
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