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

ECB Working Paper No. 977

FRB of St. Louis Working Paper No. 2004-010A

29 Pages Posted: 16 Mar 2005

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: March 2006

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. Moreover, Sarno, Valente, and Thornton (2006) find that the EH is readily rejected using more powerful multi-equation Lagrange Multiplier test developed by Bekaert and Hodrick (2001). The ubiquitous rejection of the EH raise the possibility that its failure is fundamental rather than econometric. 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-month Treasury yield implied by the EH with the forecasts from random-walk, Diebold and Lei (2003), 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 hypothesis, Time-varying risk premium

JEL Classification: E40, E52, G12

Suggested Citation

Guidolin, Massimo and Thornton, Daniel L., Predictions of Short-Term Rates and the Expectations Hypothesis of the Term Structure of Interest Rates (March 2006). ECB Working Paper No. 977; FRB of St. Louis Working Paper No. 2004-010A. Available at SSRN: https://ssrn.com/abstract=678863

Massimo Guidolin

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

Daniel L. Thornton (Contact Author)

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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