Tests of the Expectations Hypothesis of the Term Ttructure in a Model with Bayesian Learning

Paper number: 97/06

Paper date: June 1997

Year: 1997

Paper Category: Discussion Paper


George Bulkley
Richard D.F. Harris
University of Exeter

Paul Weller*
University of Iowa


Evidence that the term structure of interest rates does not satisfy the expectations hypothesis has been reported in a number of papers. However the nature and degree of this rejection is very sensitive to the exact specification of the tests. In this paper, we identify a source of small sample bias that is consistent with this empirical finding. The direction of the bias which we uncover implies that the expections hypothesis is more likely to be true than asymptotic test statistics would suggest. In financial markets, agents often receive information about the future in a form that cannot be explicityly incorporated in an econometric model. We formalise this idea by assuming that agenst supplement forecasts of the short yield obtained from the econometric model with noisy signals of the error term of the model. Using simulation experiments, we demonstrate that the bias is much more pronounced in the specification which has the more decisive rejection of the expectations hypothesis.

JEL Classification Nos: C11, G14
Keywords: Term Structure of Interest Rates, Small Sample Bias, Rational Expectations

Corresponding Author: George Bulkley, Department of Economics, University of Exeter, Amory Building, Rennes Drive, Exeter, EX4 4RJ, Great Britain, tel: (44) 1392 263214, fax: (44) 1392 263242, email: I.G.Bulkley@exeter.ac.uk


* Finance Department, College of Business Administration, University of Iowa, Iowa City, IA 52242, USA, email: paul-weller@uiowa.edu