Predictions of Short-Term Rates and the Expectations Hypothesis

Federal Reserve Bank of St. Louis Working Paper Series No. 2010-013B

53 Pages Posted: 21 May 2010 Last revised: 15 Jan 2011

See all articles by Massimo Guidolin

Massimo Guidolin

Bocconi University, Dept. of Finance; Bocconi University - CAREFIN - Centre for Applied Research in Finance

Daniel L. Thornton

Federal Reserve Bank of St. Louis - Research Division

Date Written: January 1, 2011

Abstract

Despite its role in monetary policy and finance, the expectations hypothesis (EH) of the term structure of interest rates has received virtually no empirical support. The empirical failure of the EH has been attributed to a variety of econometric biases associated with the single-equation models most often used to test it; however, none of these explanations appears to account for the massives failure reported in the literature. We note that traditional tests of the EH are based on two assumptions - the EH per se and an assumption about the expectations generating process (EGP) for the short-term rate. Arguing that convential tests of the EH could reject it because the EGP embedded in these tests is significantly at odds with the true EGP, we investigate this possibility by analyzing the out-of-sample predictive prefromance of several models for predicting interest rates and a model that assumes the EH holds. Using standard methods that take into account parameter uncertainty, the null hypothesis of equal predictive accuracy of each models relative to the random walk alternative is never rejected.

Keywords: expectations hypothesis, random walk, time-varying risk premium, predictability

JEL Classification: E40, E52

Suggested Citation

Guidolin, Massimo and Thornton, Daniel L., Predictions of Short-Term Rates and the Expectations Hypothesis (January 1, 2011). Federal Reserve Bank of St. Louis Working Paper Series No. 2010-013B, Available at SSRN: https://ssrn.com/abstract=1612403 or http://dx.doi.org/10.2139/ssrn.1612403

Massimo Guidolin (Contact Author)

Bocconi University, Dept. of Finance ( email )

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2nd floor
Milan, MI 20136
Italy

Bocconi University - CAREFIN - Centre for Applied Research in Finance

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Italy

Daniel L. Thornton

Federal Reserve Bank of St. Louis - Research Division ( email )

411 Locust St
Saint Louis, MO 63011
United States
314-444-8582 (Phone)
314-444-8731 (Fax)

HOME PAGE: http://research.stlouisfed.org/econ/thornton/

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