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Tests of the expectations hypothesis: resolving the Campbell-Shiller paradox

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Daniel L. Thornton

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Abstract

One of the more puzzling results in the expectations hypothesis (EH) testing literature is the Campbell-Shiller paradox. In an influential paper, Campbell and Shiller (1991) found that “the slope of the term structure almost always gives a forecast in the wrong direction for the short-term change in the yield on the longer bond, but gives a forecast in the right direction for long-term changes in short rates.” This paper provides an econometric resolution to the Campbell-Shiller paradox. Specifically, it shows that, by their construction, these tests can generate results consistent with the Campbell-Shiller paradox if the EH does not hold—whatever the reason. Monte Carlo experiments confirm that this explanation can account for Campbell and Shiller’s paradoxical results for most pairings of short-term and long-term rates considered.

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Paper provided by Federal Reserve Bank of St. Louis in its series Working Papers with number 2003-022.

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Date of creation: 2004
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Publication status: Published in Journal of Money, Credit, and Banking, March 2006, 38(2), pp. 511-42
Handle: RePEc:fip:fedlwp:2003-022

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Keywords: Rational expectations (Economic theory)

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  1. Silva Lopes, Artur C. & M. Monteiro, Olga Susana, 2007. "The expectations hypothesis of the term structure: some empirical evidence for Portugal," MPRA Paper 3437, University Library of Munich, Germany. [Downloadable!]
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  2. Modena, Matteo, 2008. "The term structure and the expectations hypothesis: a threshold model," MPRA Paper 9611, University Library of Munich, Germany. [Downloadable!]
  3. Daniel L. Thornton, 2003. "Testing the expectations hypothesis: some new evidence for Japan," Working Papers 2003-033, Federal Reserve Bank of St. Louis. [Downloadable!]
    Other versions:
  4. Erdenebat Bataa & Dong H. Kim & Denise R. Osborn, 2006. "A Further Examination of the Expectations Hypothesis for the Term Structure," The School of Economics Discussion Paper Series 0611, Economics, The University of Manchester. [Downloadable!]
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  5. Modena, Matteo, 2008. "Yield curve, time varying term premia, and business cycle fluctuations," MPRA Paper 8873, University Library of Munich, Germany. [Downloadable!]
  6. Metodij Hadzi-Vaskov & Clemens Kool, 2006. "The Importance of Interest Rate Volatility in Empirical Tests of Uncovered Interest Parity," Working Papers 06-16, Utrecht School of Economics. [Downloadable!]
  7. Della Corte, Pasquale & Sarno, Lucio & Thornton, Daniel L, 2007. "The Expectation Hypothesis of the Term Structure of Very Short-Term Rates: Statistical Tests and Economic Value," CEPR Discussion Papers 6445, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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