Expectation Hypothesis Bias: Risk Aversion versus Stochastic Adjustments

ADVANCE working paper Series, n. 1/2011

37 Pages Posted: 29 Mar 2014

See all articles by Renato França

Renato França

Willis Towers Watson

Raquel M. Gaspar

ISEG and Cemapre/REM, Universidade de Lisboa

Date Written: December 1, 2011

Abstract

For a long time the classical expectation hypothesis has been challenged from both empirical and theoretical perspective. Still no one could explain entirely the existent bias between expected future spot rates and forward rates, the so called puzzle in the expectation hypothesis.

In this work we will address this issue through arbitrage theory, in particular, focusing our attention in a connection of the classical expectation hypothesis to a certain probability measures where the relation between expected future spot rates and forward rates holds. We will approach this applying certain instantaneous spot rate models, verifying in these models that through changes from "real world" probability measure to other probability measures, we will find adjustments that will able us to explain this bias in the expectation hypothesis.

Suggested Citation

França, Renato and Gaspar, Raquel M., Expectation Hypothesis Bias: Risk Aversion versus Stochastic Adjustments (December 1, 2011). ADVANCE working paper Series, n. 1/2011, Available at SSRN: https://ssrn.com/abstract=2417268 or http://dx.doi.org/10.2139/ssrn.2417268

Renato França

Willis Towers Watson ( email )

875 Third Avenue
New York, NY 10022
United States

Raquel M. Gaspar (Contact Author)

ISEG and Cemapre/REM, Universidade de Lisboa ( email )

Rua Miguel Lupi, 20
room 510
Lisbon, 1249-078
Portugal

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