THE RATIONAL EXPECTATIONS HYPOTHESIS OF THE TERM STRUCTURE: RECONCILING THE EVIDENCE

Paper number: 94/02

Year: 1994

Paper Category: Discussion Paper

Authors

Elias Tzavalis
University of Exeter

Micheal Wickens
Department of Economics, University of York

Abstract

The main aim of this paper is to test the rational expectations hypothesis of the term structure (REHTS). Existing empirical studies of the REHTS provide inconsistent evidence. Tests based on the local expectations hypothesis (LEH) version of the REHTS tend to be far less supportive than those based on the return to maturity expectations hypothesis (RTMEH), especially when they concern the short-run implications of the hypothesis. This paper explains the differences between these alternative versions of the REHTS and estimates a number of models to try to explain the inconsistencies in previous results. Our conclusions are that the most probable cause of these differences is the failure to take account of the presence of a time-varying term premium. Once this is accounted for both short-run and long-run evidence is found to support the REHTS. Estimates of variance bounds of the term premium suggest that it may not vary sufficiently to be the sole explanation for the differences.

JEL Classification numbers: C32, C52.
Keywords: Term structure, rational expectations, cointegration, VAR.

The authors would like to thank I.Cooper, S.Hall, F.Palm, and Z.Psaradakis and seminar participants at London Business School for helpful comments. Any remaining errors are our own. This research was funded by the ESRC under the grant R00232696.