The paper presents a one-factor affine model of the term structure of Libor
rates with autocorrelated measurement errors. It can be viewed as a central
tendency model, with the theoretical arbitrage-free rates serving as stochastic
means to which the observed rates revert. Two estimation techniques are
compared, one based on a no-measurement-error assumption, the other on Kalman
filtering. The estimates are then used in standard yield spread regressions with
a view to accounting for the departure of future short rates from what the
expectations hypothesis would predict.
The views expressed in this publication are those of the authors and do not necessarily reflect the views of the BIS or its member central banks.