The Expectations Hypothesis of the Term Structure and Time‐Varying Risk Premia: a Panel Data Approach
| DOI | http://doi.org/10.1111/1468-0084.00218 |
| Author | Richard D. F. Harris |
| Date | 01 May 2001 |
| Published date | 01 May 2001 |
The expectations hypothesis of the term
structure and time-varying risk premia: a
panel data approachy
Richard D. F. Harris
School of Business and Economics, University of Exeter
I. Introduction
Theories of the term structure of interest rates are central to the implementa-
tion of monetary policy, providing the link between the short term interest
rate that is under the control of the monetary authorities, and the long term
interest rates that the authorities may ultimately want to in¯uence. The most
enduring of these theories is the expectations hypothesis of the term structure
of interest rates, formulated more than ®fty years ago by Lutz (1940). The
expectations hypothesis states that the expected holding period return is equal
for all bond maturities except for an additive maturity-speci®c risk premium
that is constant over time.
One implication of the expectations hypothesis is that the spread between
the yields on short and long maturity bonds should forecast next period's
change in the yield on the long maturity bond. In particular, when the long
yield exceeds the short yield, the long yield should be expected to rise in
order to generate the capital loss required to offset the initial yield premium.
Under the assumption of rational expectations, this hypothesis can be easily
formulated as a regression of the ex post one period change in the long yield
on the current yield spread. When the spread is appropriately scaled, the
estimated coef®cient should be unity under the expectations hypothesis.
Empirical evidence using this formulation leads to an overwhelming
rejection of the expectations hypothesis. The estimated coef®cient is found to
be not only signi®cantly less than unity, but also signi®cantly less than zero
for all but the shortest maturity bonds, implying that when long yields exceed
OXFORD BULLETIN OF ECONOMICS AND STATISTICS, 63, 2 (2001) 0305-9049
#Blackwell Publishers Ltd, 2001. Published byBlackwell Publishers, 108 Cowley Road, Oxford OX4 1JF, UKand 350
Main Street, Malden, MA 02148, USA.
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yI am grateful to the editor and a referee for useful comments and suggestions.
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