The expectations hypothesis of the term structure and time varying risk premia: a panel data approach

Paper number: 98/11

Paper date: August 1998

Year: 1998

Paper Category: Discussion Paper


Richard D Harris
University of Exeter


The expectations hypothesis of the term structure of interest rates implies that the spread between short and long bond yields should forecast next period's change in the long yield. Regression based tests have systematically rejected the expectations hypothesis, with estimated coefficients far from their hypothesised values. One explanation of this rejection is that regression tests fail to account for time varying risk premia that are correlated with the spread, causing a downward bias in the estimated regression parameters. This paper uses panel data in order to test the expectations hypothesis in the presence of time varying risk premia. It is assumed that risk premia are driven by a single factor and that they are linear in bond maturity. This allows the unobserved time varying risk premia to be captured by time-specific fixed effects in a panel data regression. The hypothesis that risk premia are linear in maturity is tested by the inclusion of bond specific fixed effects in the regression. The bond specific effects are not significant, implying that risk premia are well approximated by a linear single factor model. When risk premia are handled in this way, the bias in the estimated coefficient is substantially reduced, although the expectations hypothesis is still rejected.

JEL Classification Nos: C11; G14
Keywords: Expectations hypothesis of the term structure of interest rates; time varying risk premia; panel data; fixed effects

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: