Predictions of Short-Term Rates and the Expectations Hypothesis of the Term Structure of Interest Rates

32 Pages Posted: 23 Dec 2008

See all articles by Massimo Guidolin

Massimo Guidolin

Bocconi University - Department of Finance

Daniel L. Thornton

Federal Reserve Bank of St. Louis - Research Division

Multiple version iconThere are 2 versions of this paper

Date Written: December 3, 2008

Abstract

Despite its important 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 was attributed to a variety of econometric biases associated with the single-equation models used to test it; however, none account for it. This paper analyzes the EH by focusing on its fundamental tenet - the predictability of the short-term rate. This is done by comparing h-month ahead forecasts for the 1- and 3-month Treasury yields implied by the EH with the forecasts from random-walk, Diebold and Lei (2006), and Duffee (2002) models. The evidence suggests that the failure of the EH is likely a consequence of market participants' inability to predict the short-term rate.

Keywords: expectations theory, random walk, time-varying risk premium

JEL Classification: E40, E52

Suggested Citation

Guidolin, Massimo and Thornton, Daniel L., Predictions of Short-Term Rates and the Expectations Hypothesis of the Term Structure of Interest Rates (December 3, 2008). ECB Working Paper No. 977. Available at SSRN: https://ssrn.com/abstract=1310613

Massimo Guidolin (Contact Author)

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
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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