A test of the expectations hypothesis of the term structure using cross-section data

Paper number: 98/12

Paper date: August 1998

Year: 1998

Paper Category: Discussion Paper


Richard D Harris
University of Exeter


Empirical tests of the expectations hypothesis of the term structure have almost without exception been tests of the time-series properties of interest rates. However, the expectations hypothesis has implications not just for the yield movement of a single pair of bond maturities over a number of periods but also for the relationship between yield movements of a number of bond maturities over a single period. This paper tests these implications of the expectations hypothesis using cross-section bond yield data. A long series of monthly cross-section regressions is estimated using zero coupon bond yields for maturities from two months to thirty-five years. The expectations hypothesis is tested using the time-series average of the estimated slope parameter in the cross-section regressions. Three versions of the expectations hypothesis are tested: the pure expectations hypothesis, which does not allow for a risk premium, the constant risk premium expectations hypothesis, which allows for a maturity-specific risk premium that is constant over time, and a generalisation of the expectations hypothesis in which the maturity-specific risk premium is time-varying. The risk premium is proxied by the expected absolute value of the excess holding period return. Consistent with evidence from time series studies, both the pure expectations hypothesis and the constant risk premium expectations hypothesis are strongly rejected. However, once allowance is made for a time varying risk premium, the expectations hypothesis cannot be rejected, with estimated parameters very close to their hypothesised values.

JEL Classification Nos: C21; G14
Keywords: Expectations hypothesis of the term structure of interest rates; cross-section regression test; Fama and MacBeth procedure

Corresponding Author: Richard D Harris, Department of Economics, University of Exeter, Streatham Court, Rennes Drive, Exeter, EX4 4PU, UK, tel: (44) 1392 263215, fax: (44) 1392 263242, email: R.D.F.Harris@exeter.ac.uk


I would like to thank George Bulkley, Kaddour Hadri and Elias Tzavalis.